In Finance, what is Overshooting?

Overshooting is an economic phenomenon that has to do with the exchange rate. The term is used to describe both a logical chain of events that occurs in the marketplace when there is a shift in the balance between quantities and prices, as well as the manner in which an investor responds to those shifts. In both instances, the phenomenon is considered to be of short duration, with balance restored once the economy has completed all phases of the shift and accommodated to the new circumstances.

In terms of identifying overshooting in the economy, this phenomenon takes place when some type of change in monetary policy undermines the current balance between prices and quantities. For example, if the market is flooded with increased quantities, the reaction is likely to be a drop in prices. The decrease in prices may be somewhat severe at first, reaching a much lower figure. However, as the market adjusts to the new circumstances, the price is likely to increase slightly as quantities become stable once more, creating a new equilibrium. At this point, the phase of overshooting is considered complete.

This same set of changing circumstances can also trigger a reaction by investors that is identified as overshooting. In this scenario, the investor reacts to the shifts in the marketplace by working to help drive the change in exchange rate as quickly as possible. The idea is to take actions that will move the marketplace through the period of relative upheaval at a faster pace, thus restoring equilibrium to the marketplace sooner rather than later. Often, this is done in hopes of avoiding losses on investments, as well as taking advantage of temporarily low prices in order to make new acquisitions that will begin to appreciate in value as the market begins to restore the balance between quantity and price.

Many events can take place during a phase of overshooting. Refinancing of holdings such as real estate may take place. Investments may be bought and sold at an accelerated rate. The rate of prepayments on liabilities may occur, or the rate of the repayment of liabilities may slow, depending on the nature of the market shift and the effect that it has on the exchange rate. By understanding the nature of the change, including what prompted the change to take place, it is possible to determine what strategies are necessary to avoid loss during the transition and what can be done to help establish this new long-run equilibrium value to the exchange rate.