What it means
Hedging is the use of financial contracts, such as forwards or options, to cancel out the effect of price movements on a business. For example, an exporter expecting foreign currency payments might sell that currency forward to lock in a rate.
The aim is for the gain on the hedge to offset the loss on the exposure. Overhedging occurs when the hedge is larger than the exposure.
If the exporter hedges $1,300,000 but eventually receives only $1,000,000, the extra $300,000 has nothing behind it, and the company gains or loses on it depending on market moves. That means the hedge has introduced a new risk.
The usual causes are forecasting errors, cancelled orders, delayed sales and layering hedges over time without reviewing them. Another cause is hedging gross exposures when some are already offset by opposite exposures elsewhere in the group.
Treasury teams should reconcile hedges to exposures regularly. There are also accounting consequences.
Hedge accounting rules allow gains and losses on a hedge to be matched with the item being hedged only to the extent that the hedge is effective. The over-hedged part generally has to be recognised in profit or loss straight away, which can make results more volatile.
Firms control the problem by hedging only a percentage of forecast exposure, such as 50% to 80%, and by updating the numbers as sales forecasts change. A written policy and regular reports to the board make it far less likely.
A related problem is underhedging, where the hedge is too small and leaves part of the exposure open. Good treasury policy sets both a floor and a ceiling for the hedge ratio so that neither error builds up unnoticed.
In practice
Real-world examples.
Example
An airline hedges fuel prices for 90% of expected use, then cuts routes after a downturn. Actual fuel use falls to 70% of the forecast. The airline is now overhedged by 20% of the original forecast and carries losses if fuel prices fall.
Example
A manufacturer sells a foreign currency forward to cover a large export order of $2,000,000. The customer cancels half the order. The business is left with $1,000,000 of hedging with no exposure behind it.
Example
A multinational hedges each subsidiary's foreign exposure separately, without noticing that group-wide the exposures partly cancel each other out. The overall hedge is larger than the net risk. The treasury team fixes this with a central exposure report.
Formula
Calculation
Hedge ratio = hedge amount / underlying exposure
Overhedged amount = hedge amount - underlying exposure
A company expects to receive $1,000,000 in foreign currency and sells $1,300,000 forward. Hedge ratio = 1,300,000 / 1,000,000 = 1.3, or 130%. Overhedged amount = 1,300,000 - 1,000,000 = $300,000. If the foreign currency then rises 5% against the home currency, the company loses 5% on the excess forward sale, which is 300,000 x 0.05 = $15,000, with nothing in the business to offset it.
Reading the result: a ratio above 100% is the signal for overhedging, and here the 130% ratio means 30 cents in every dollar of hedge has no exposure behind it. A 5% move in the opposite direction would have cost $15,000, and a 5% move in the favourable direction would have gained the same amount, which shows why the position is speculative.Case study
Seen in the real world.
Silverbrook Exports is an illustrative, fictional food exporter that agreed to sell $5,000,000 of produce to overseas supermarkets. To protect its margin, the treasurer sold the full amount of the foreign currency forward.
A poor harvest meant the company could deliver only $3,500,000 of produce. The currency then strengthened by 6% against the home currency, and the company lost money on the $1,500,000 of forward contracts it no longer needed.
The loss was 1,500,000 x 0.06 = $90,000, which wiped out a large part of the season's profit. The board revised the policy to hedge no more than 70% of forecast sales until orders were confirmed, and this is an illustrative reminder to hedge exposures and not hopes.
Watch out
Common mistakes.
- Hedging the full forecast when the forecast is uncertain, which creates an overhedge if sales fall short.
- Forgetting to adjust the hedge when orders are cancelled or delayed.
- Treating gains on the excess hedge as safe profit, when the same position can lose just as easily.
Questions
People also ask.
Is overhedging always a loss?
No, the extra position can make a gain or a loss, but it is speculation and not protection, which is why most policies forbid it.
What is a safe hedge ratio?
Many firms hedge between half and most of their forecast exposure, with the exact level depending on how certain the cash flows are.
How do you fix an overhedge?
You close or reduce the excess contracts, which may produce a gain or a loss, and update the policy and the forecast.
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