Avoiding the Pitfalls of Over-Hedging in FX Trading

Over-hedging in FX trading

Over-hedging occurs when a company seeking to hedge its currency exposure buys more hedging instruments, such as forwards or options, than needed, surpassing the underlying exposure level. The most obvious reason for over-hedging is inaccurate forecasting however, economic and business changes, an inappropriate risk management strategy, or poor individual decisions, such as emotional or market-based trading, are also common factors for over-hedging.

Risks associated with over-hedging

If the aggregate over-hedged position is fortuitously in-the-money, the company could close the positions for profit but, we can’t rely on such outcomes. The risks of over-hedging include trading costs for rolling/extending hedging trades, losses from closing-out out-of-the-money positions, margin calls, accounting losses, and business performance issues with carrying forward unfavourable exchange rates into future periods.

What strategies/tips do you recommend?

The perfect hedging ratio is unique to each business, and it is often elusive. To avoid excessive over- or under-hedging, a company should work to a defined currency hedging strategy within a broader FX policy. The strategy will include details of when and how much to hedge, eliminating any possibility of individual poor decisions as accountability is shared. Regarding the specifics of the strategy itself, the company should back-test their forecast accuracy, factoring economic cycles and market dynamics (their market) – this should indicate an appropriate hedging ratio to work to. Remember, the idea is to reduce risk to acceptable levels, not necessarily to zero. There may not be a perfect hedge for most businesses, but it’s feasibly to get close.

Get in touch with treasuryXL expert Harry Mills for additional information on over-hedging in FX management.