What is over-coverage?
Over-hedging is a risk management strategy that uses an offsetting position that exceeds the size of the original position being hedged. The result can be a net position in the opposite direction from the starting position.
Excess coverage can be unintentional or intentional.
- Over-hedging occurs when an offsetting position is established that exceeds the original position.
- Whether intentional or not, the headline results in a position that is clearly the opposite of the original.
- Like under hedging, over hedging is an inappropriate use of a hedging strategy.
When over-hedged, the hedging is for an amount greater than the underlying position initially held by the hedging company. The overcut position essentially sets a price for more goods, raw materials, or securities than is necessary to protect the position held by the company. When a company has excessive hedging, it affects the ability to profit from the original position.
Example of excessive coverage
Excessive hedging in the futures market can be a matter of incorrectly adjusting the contract size to need. For example, let’s say a natural gas company entered into a futures contract in January to sell 25,000mm British Thermal Units (mmbtu) at $ 3.50 / mmbtu. However, the company only has an inventory of 15,000 mmbtu that they are trying to cover. Due to the size of the futures contract, the company now has excess futures contracts amounting to 10,000 mmbtu. Those 10,000 mmbtu in excess hedging actually opens the company up to risk as it becomes a speculative investment if they don’t have the underlying deliverable in hand when the contract expires. They would have to go out and put it on the open market to make a profit or loss, depending on what the price of natural gas does during that time period.
Any drop in the price of natural gas would be covered by the hedge, protecting the company’s inventory price, and the company would make an additional profit by delivering the excess quantity at a higher contract price than what it can buy in the market. . However, an increase in the price of natural gas would cause the company to earn less than market value on its inventory and then it would have to spend even more to cover the excess by buying it at the higher price.
Excess coverage is often done by mistake; But for many companies, the lack of coverage is a much greater risk.
Over-Hedging versus No Hedging
As shown above, excessive hedging can create additional risk rather than eliminate it. Over-hedging is essentially the same as under-hedging in that both are inappropriate uses of the hedging strategy.
Of course, there are situations where poorly configured coverage is better than no coverage. In the natural gas scenario above, the company sets its price for all of its inventory and then speculates on market prices by mistake. In a declining market, excessive hedging helps the company, but the important point is that the lack of hedging would mean a deep loss in all of the company’s inventory.