What is over-coverage?
Overhedging is a risk management strategy in which a clearing position which exceeds the original position is initiated. Sometimes a company may establish a clearing position that exceeds its exposure or its actual risk.
Key points to remember
- Overhedging is a risk management strategy in which a clearing position which exceeds the original position is initiated.
- When a company is over-hedged, it affects the ability to take advantage of the original position.
- Overcovering is essentially the same as undercovering, in that both are inappropriate uses of the hedging strategy.
Essentially, the hedge is in an amount greater than the underlying position held by the company that enters into the hedge. The over-hedged position essentially blocks a price for more goods, commodities or securities than necessary to protect the position held by the company. When a company is over-hedged, it affects the ability to take advantage of the original position.
Over-hedging in the futures market can be a question of incorrectly matching the size of the contract to needs. For example, let’s say a natural gas company entered into a January futures contract to sell 25,000mm (mmbtu) British thermal units at $ 3.50 / mmbtu. However, the company only has an inventory of 15,000 mmbtu which it is trying to cover. Due to the size of the futures contract, the company now has excess futures contracts of 10,000 mmbtu. These 10,000 mmbtu of over-coverage actually opens the company to risk, because it becomes a speculative investment because they do not have the underlying deliverable on hand when the contract expires; they should go out and put it on the open market for a profit or a loss depending on what the price of natural gas does during that period.
Any drop in the price of natural gas would be covered by the hedge, protecting the price of the company’s inventory, and the company would gain additional profit by delivering the excess at a higher contractual price than it can buy on the market. An increase in the price of natural gas, however, would see the company doing less than the market value of its inventory and would then have to spend even more to make up the surplus by buying it at the higher price.
Over-coverage against lack of coverage
As noted above, overcovering can actually create additional risk rather than removing it. Overhedging is essentially the same as undercovering in that both are inappropriate uses of the hedging strategy. There are, of course, situations where poorly configured coverage is better than no coverage at all. In the natural gas scenario above, the company locks in its price for all of its inventory, then mistakenly speculates on market prices. In a bear market, over-coverage helps the business, but the important point is that the absence of coverage would cause a deep loss on all the company’s stocks. Simply put, over-coverage is a mistake, but for many companies, the lack of coverage represents a much greater risk.