Under hedging

What Is Under Hedging?

Under hedging occurs when a party's hedging activities are insufficient to fully offset their underlying financial exposure to a specific risk. This strategy, or often a consequence of an imperfect strategy, falls under the broader category of risk management in finance. Instead of completely neutralizing potential losses from adverse market movements, under hedging leaves a portion of the risk uncovered. This could be due to a deliberate choice to save on hedging costs, an inaccurate forecast of future liabilities or assets, or an unexpected change in market conditions. When a company or individual under hedges, they remain vulnerable to the financial impact of the unhedged portion of their exposure.

History and Origin

The concept of hedging itself dates back centuries, evolving from early forms of forward contracts in agricultural markets to sophisticated financial derivative instruments today. The specific notion of "under hedging" emerged as financial markets grew more complex, and companies increasingly adopted formal risk management strategies. As corporate hedging practices became more widespread, particularly in managing foreign exchange risk and interest rate risk, the challenges of imperfect hedging also became apparent. Discussions around the optimal level of hedging, and the pitfalls of both under- and over-hedging, became central to corporate treasury and finance. For instance, the Federal Reserve Bank of New York has published insights on managing foreign exchange risk, highlighting the multifaceted nature of market risks and the strategies to mitigate them.⁹ Furthermore, academic and industry analyses, such as those discussed by NYU Stern, outline that an effective hedging program does not aim to eliminate all risk but rather to transform unacceptable risks into an acceptable form.⁸ This perspective implicitly acknowledges that some degree of under hedging might be a conscious decision, balancing protection against the costs of hedging.

Key Takeaways

• Under hedging means that a portion of financial risk remains unprotected despite hedging efforts.
• It can arise from deliberate choices, such as cost-saving measures, or from imperfect forecasting.
• Under hedging leaves an entity vulnerable to adverse market movements on the unhedged portion.
• The consequences can include financial losses, reduced profit margins, and increased earnings market volatility.
• Effective risk management involves balancing the benefits of protection against the costs and complexities of hedging.

Formula and Calculation

Under hedging doesn't have a specific mathematical formula in the way a derivative's value might. Instead, it describes a state where the ratio of the hedged amount to the total exposure is less than 1 (or 100%).

Consider a company with a total financial exposure to a particular risk, such as a foreign currency receivable.
Let:

• (E) = Total Exposure (e.g., amount of foreign currency expected)
• (H) = Amount of Exposure Hedged (e.g., amount of foreign currency locked in via a forward contract)

The "hedge ratio" or "coverage ratio" can be expressed as:

Under hedging occurs when:

For example, if a company expects to receive $1,000,000 in foreign currency but only hedges $700,000 using a financial instrument, the hedge ratio is 0.7 or 70%. The remaining $300,000 is unhedged, representing the under-hedged portion.

Interpreting Under Hedging

Interpreting under hedging requires understanding the reasons behind it and the potential implications. When a company under hedges, it implies a conscious decision or an unforeseen circumstance led to less-than-full coverage of a particular risk. For instance, a treasurer might opt for under hedging to reduce the cost of derivative contracts or to retain some upside potential if the market moves favorably. However, this also means accepting potential downside risk.

If a business primarily uses forward contracts or futures contract to manage foreign currency risk, under hedging would mean a portion of their future cash flows remains exposed to currency fluctuations. The impact of under hedging is realized when the unhedged portion of the exposure is settled at the prevailing spot rate. If the market moves unfavorably for the unhedged amount, the company will incur losses that could have been avoided with a full hedge. Conversely, if the market moves favorably, the company benefits from the unhedged portion.

Hypothetical Example

Consider a U.S.-based technology company, TechGlobal Inc., that expects to receive €5,000,000 from a European client in three months. TechGlobal's treasury department decides to hedge 80% of this exposure to manage foreign exchange risk. They enter into a forward contract to sell €4,000,000 at a locked-in exchange rate of 1.08 USD/EUR.

This means TechGlobal has under-hedged by €1,000,000 (€5,000,000 - €4,000,000).

After three months, the payment is due:

• Scenario 1: Euro depreciates. The spot rate is now 1.05 USD/EUR.

  • The hedged €4,000,000 is converted at 1.08 USD/EUR, yielding $4,320,000.
  • The unhedged €1,000,000 is converted at the spot rate of 1.05 USD/EUR, yielding $1,050,000.
  • Total USD received: $4,320,000 + $1,050,000 = $5,370,000.
  • If they had fully hedged at 1.08, they would have received $5,400,000 (€5,000,000 * 1.08). The under hedging resulted in $30,000 less than a full hedge.

• Scenario 2: Euro appreciates. The spot rate is now 1.10 USD/EUR.

  • The hedged €4,000,000 is converted at 1.08 USD/EUR, yielding $4,320,000.
  • The unhedged €1,000,000 is converted at the spot rate of 1.10 USD/EUR, yielding $1,100,000.
  • Total USD received: $4,320,000 + $1,100,000 = $5,420,000.
  • If they had fully hedged at 1.08, they would have received $5,400,000. In this scenario, the under hedging resulted in $20,000 more than a full hedge.

This example illustrates that while under hedging carries the risk of lower returns in unfavorable market conditions, it also allows for potential upside gains if the market moves advantageously for the unhedged portion.

Practical Applications

Under hedging is a common feature in many real-world financial scenarios, often arising in large corporations with complex international operations.

• Corporate Treasury Management: Companies engaged in international trade or with foreign subsidiaries frequently face foreign exchange risk. They might under hedge anticipated foreign currency revenues or expenses due to uncertainty in sales volumes, or as a strategic decision to retain some exposure to potential favorable currency movements. For example, a multinational corporation with recurring foreign currency cash flows might use a portfolio of forward contracts or option contract to manage risk, but not necessarily cover 100% of their forecasted exposure.
• Commodity Pri⁷ce Risk: Producers or consumers of raw materials (e.g., oil, metals, agricultural products) may under hedge their commodity price exposure. This could be because they believe prices might move favorably, or they want to benefit from potential price increases, choosing to accept the risk of price declines on the unhedged portion.
• Interest Rate Risk: Businesses with floating-rate debt may under hedge their interest rate risk if they anticipate interest rates will fall, or if they wish to reduce the cost of interest rate swaps. This leaves them exposed to rising rates on the unhedged portion of their debt.
• Global Hedging Trends: In periods of significant market volatility, corporate treasurers are under pressure to protect profit margins. While many companies actively hedge, the average hedge ratio is often below 100%, indicating a degree of under hedging is common practice globally. This reflects a balance between risk protection and the cost of hedging.

Limitations and⁶ Criticisms

Under hedging, while sometimes a deliberate strategy, carries significant limitations and criticisms, primarily centered around the potential for unexpected financial losses and increased earnings market volatility.

One of the primary criticisms is that it can lead to financial losses when adverse market movements occur on the unhedged portion of the exposure. This directly impacts profit margins and earnings stability, making financial results less predictable. For example, a comp⁵any that under hedges its foreign exchange risk could see its anticipated foreign currency revenue significantly reduced if the foreign currency depreciates unexpectedly against its home currency. This can even lead to a paradoxical situation where higher sales volumes result in lower total revenue in the home currency due to the unhedged portion.

Another limitation⁴ stems from the inherent difficulty in accurately forecasting future market movements or cash flows, which is a leading cause of under hedging. If the forecasts ar³e inaccurate, the planned under hedging could inadvertently become a much larger unhedged exposure than intended, leading to greater risk than anticipated. Changes in economic conditions, geopolitical events, or even internal business changes (like shifts in supplier locations or sales volumes) can disrupt carefully planned hedging strategies, resulting in an unintended under-hedged position.

Furthermore, under hedging can increase a company's basis risk, which occurs when the price of the hedging instrument does not perfectly correlate with the price of the underlying asset being hedged. Even with a partial hedge, differences between the hedged amount and the actual exposure, or mismatches in timing and instrument characteristics, can still lead to unexpected outcomes.

Under Hedging v²s. Over Hedging

Under hedging and over hedging represent two opposite extremes in a risk management strategy. Both involve a mismatch between the volume of a company's financial exposure and the amount covered by derivative contracts or other hedging activities.

While under hedging leaves an entity exposed to a portion of the original risk, over hedging can introduce new risks, as the excess hedged amount effectively becomes a speculative position. The optimal approach often lies in finding a balanced hedging ratio that aligns with the organization's risk appetite and strategic objectives.

FAQs

What is the primary risk of under hedging?

The primary risk of under hedging is that the unhedged portion of an exposure remains vulnerable to adverse market movements, which can lead to financial losses, reduced profit margins, and increased earnings market volatility.

Why would a company intentionally under hedge?

A company might intentionally under hedge to reduce the costs associated with hedging instruments, such as premiums for option contracts or fees for forward contracts. Additionally, they might choose to retain some upside potential if they anticipate favorable market movements that would benefit their unhedged position.

Can under hedging ever be beneficial?

Yes, under hedging can be beneficial if the market moves favorably for the unhedged portion of the exposure. For instance, if a company under hedges a foreign currency receivable and that foreign currency appreciates, the unhedged portion will convert into more of the home currency, resulting in a higher total value than if it had been fully hedged. However, this benefit comes with the risk of losses if the market moves unfavorably.