underhedging

Underhedging is a risk management situation in which a hedging program does not provide sufficient protection against a known or anticipated exposure. It occurs when the hedge ratio is less than one, leaving residual risk that can materialize if market conditions move unfavorably. Underhedging contrasts with overhedging, where the hedge exceeds the exposure, and with schemes aimed at achieving a perfect hedge, which are rarely attainable in practice.

Causes of underhedging include an incomplete assessment of exposure, basis risk (the hedge instrument does not move in perfect sync with the underlying exposure), limited availability or liquidity of hedging instruments, and cost or capital constraints that discourage full coverage. Forecast errors, timing mismatches between hedging and exposure, and infrequent rebalancing can also contribute. In some cases, underhedging reflects a deliberate risk tolerance or a strategic choice to reduce hedging costs or preserve upside potential.

The implications of underhedging are higher potential earnings or value volatility when market moves are adverse. For a company with foreign exchange, interest rate, or commodity price exposure, inadequate hedging can translate into unexpected cash flows and volatility in earnings. However, reduced hedging can also leave more capital available for other activities and may be chosen when hedging costs or complexities outstrip the expected benefit.

Management approaches to mitigate underhedging include refining exposure measurement, employing a broader set of hedging instruments (including cross-hedges or options), dynamic hedging and rebalancing, backtesting, and comprehensive risk governance to align hedges with risk tolerance and strategic objectives.