Over-hedging
Hedging a larger position than the actual underlying exposure calls for, which turns a risk-reducing strategy into an unintended speculative bet.
In plain language
A hedge is only a hedge if it is sized to match a real exposure. Hedge more than that, and the extra amount is no longer protecting anything — it is a separate bet dressed up as risk management.
The workbook lists this directly as a way a hedging strategy can go wrong, alongside simple cost and the risk of capping potential gains.
How it works
The workbook: "effective hedging requires careful planning and understanding of market instruments. Over-hedging or incorrect strategies can increase risk instead of reducing it." This follows directly from its hedge ratio framework in Chapter 11.9.1 — the hedge ratio calculates exactly how much of a position should be hedged, and hedging beyond that calculated amount is what over-hedging means in practice.
A worked example
Using the workbook's own hedge ratio worked example: ABC Company's monthly copper requirement is 100 MT, and its calculated hedge ratio of 0.915 means it should hedge 91.5 MT — 37 contracts of 2.5 MT each.
If ABC instead hedges 150 MT, taking out 60 contracts, it is over-hedged by 58.5 MT beyond what its exposure and hedge ratio call for. That extra 58.5 MT is no longer offsetting a real purchase requirement — it is a naked speculative futures position that can generate a loss on a price move a correctly sized hedge would never have been exposed to.
Why NISM asks about it
Chapter 11.9 (Hedging in Commodities) and 11.9.1 (Hedge Ratio) set out the calculation this concept builds on. Expect a question naming over-hedging as a disadvantage of hedging, or a scenario comparing an actual hedge size against the hedge ratio's calculated figure.
Common exam traps
- Over-hedging is not "hedging carefully" — it is hedging beyond the calculated exposure. The workbook lists it as a genuine disadvantage of hedging, alongside cost and capped upside, not as an example of good risk management.
Check yourself
1.Correlation between spot and futures is 0.9853, SD of change in spot price is 9.02 and SD of change in futures price is 9.71. On a 100 MT exposure, with a 2.5 MT contract, how many contracts should be hedged?
- a)40 contracts
- b)37 contracts
- c)36 contracts
- d)46 contracts
Show the answer
Answer: (b) 37 contracts
Step 1 — the hedge ratio. 0.9853 × (9.02 ÷ 9.71) = 0.9853 × 0.9289 = 0.915.
Step 2 — quantity. 0.915 × 100 MT = 91.5 MT — the workbook's No. of Quantity to be Hedged: 91.5.
Step 3 — contracts. 91.5 ÷ 2.5 = 36.6, and the workbook rounds up: to cover the risks of 100 MTs, ABC Company has to hedge 91.5 MTs of copper, which is 37 contracts as the copper contract on MCX is 2.5 MTs contract.
Option A (40) is the un-hedged full exposure — 100 ÷ 2.5 — which ignores the hedge ratio entirely. That is the over-hedge the chapter warns against: over-hedging or incorrect strategies can increase risk instead of reducing it.
Option C (36) truncates instead of rounding up, leaving part of the exposure uncovered.
Why hedge only 91.5% rather than the whole 100 MT? Because spot and futures do not move identically. The correlation is high at 0.9853 but not 1, and futures here are slightly more volatile than spot (9.71 against 9.02), so each futures contract does slightly more work than one unit of physical exposure.
The three-step method — ratio, then quantity, then contracts — is what to carry into the exam, since the exposure and lot size will differ from the workbook's.
Where this is taught
Free preparation for NISM Series XVRelated terms
- BrentThe benchmark crude oil price for oil produced in Europe and Africa, sourced from the North Sea and traded on ICE — one of the two global oil pricing benchmarks alongside WTI.
- Crop reportA government or research-agency publication giving acreage, planting progress, yield estimates and production levels for a crop — a key input to predicting agricultural commodity prices.
- Hedging disclosure normsSEBI's requirement, dated 15 November 2018, that a listed company disclose its commodity risk policies and, for each commodity, its exposure and the extent hedged in domestic and international markets.
- Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.