counterhedging

CounterHedging is a risk-management approach in which an investor or trader takes additional positions specifically to offset the residual risks introduced by an initial hedge. The goal is to hedge the hedge, reducing basis risk, model risk, or changes in the hedged position’s sensitivity as market conditions evolve.

It typically arises when a primary hedge (such as forwards, futures, options, or swaps) cannot fully offset the target exposure due to imperfect correlation, non-linear payoffs, or costs of the hedge. A counter-hedge may involve taking a second hedge in a related instrument, or dynamically adjusting positions to maintain a target net exposure. For example, a commodity trader hedging with futures contracts in one month and facing contango or backwardation might add a cross-hedge in a related contract or use options to cap downside while preserving some upside. In currency risk, a manager might hedge a cash flow with forwards and simultaneously purchase options to limit rare, large moves that would erode hedge effectiveness.

Advantages include improved risk control, more robust protection against unforeseen moves, and flexibility in managing complex risk profiles. Disadvantages include higher transaction costs, greater complexity, potential over-hedging, and the risk that the counter-hedge itself introduces new sensitivities to model assumptions and market conditions.

CounterHedging is related to concepts such as hedging, delta hedging, cross-hedging, basis risk, and tail risk management. It is most commonly used by professional traders, risk managers, and institutions with sophisticated risk models.