Overhedging

Overhedging is a risk management condition in which the size of a hedge exceeds the exposure it is intended to offset. It occurs when the hedge ratio—defined as the notional value of the hedge divided by the exposure—exceeds one, or when hedging instruments interact with the underlying asset in a way that leaves the net position partially or wholly overprotected or exposed to other risks.

Causes of overhedging include misestimation of exposure, choosing hedging instruments with larger notional values than necessary, dynamic hedging errors, and changes in the correlation between the hedge and the exposure (basis risk). Overhedging can be intentional, for example to anticipate potential increases in exposure or to cover multiple risk factors, or it can be the result of model or implementation errors.

The effects of overhedging are mixed. While a hedge that is too large may reduce downside risk more than intended, it can also cap upside potential and create new risks. If market movements occur in ways not perfectly aligned with the hedge, the net position may still incur losses. Additionally, overhedging can lead to higher costs, operational complexity, and potential accounting or regulatory implications.

Measurement and terminology: a hedge ratio greater than 1.0 indicates overhedging; a ratio less than 1.0 indicates underhedging; a ratio of 1.0 represents a full hedge. Hedging instruments commonly involved include futures, options, swaps, and cross-hedges using related assets. The success of a hedge depends on the correlation, liquidity, and transaction costs of the instruments used.