Cross Hedge

What Is Cross Hedge?

Cross hedging alludes to the practice of hedging risk utilizing two distinct assets with decidedly correlated price developments. The investor takes restricting positions in every investment trying to reduce the risk of holding just one of the securities.

Since cross hedging depends on assets that are not impeccably corresponded, the investor accepts the risk that the assets will move in inverse headings (in this manner making the position become unhedged).

Figuring out Cross Hedge

Cross hedging is normally used by investors who purchase [derivative products](/derivative, for example, commodity futures. By utilizing commodity futures markets, traders can buy and sell contracts for the delivery of commodities at a predetermined future time. This market can be important for companies that hold large amounts of commodities in inventory, or who depend on commodities for their operations.

For these companies, one of the major risks facing their business is that the price of these commodities might change quickly in a manner that disintegrates their profit margin. To relieve this risk, companies embrace hedging strategies that permit them to lock in a price for their commodities that actually permits them to create a gain.

For instance, fly fuel is a major expense for airline companies. Assuming the price of fly fuel rises quickly, an airline company might not be able to operate profitably given the higher prices. To relieve this risk, airline companies can buy futures contracts for fly fuel. Futures contracts permit airlines to pay one price today for their future fuel needs and permits them to guarantee that their margins will be kept up with (paying little mind to what ends up fueling prices from here on out).

There are a few cases, be that as it may, where the ideal type or quantity of futures contracts are not accessible. In that situation, companies are forced to carry out a cross hedge, by which they utilize the nearest alternative asset accessible.

For instance, an airline may be forced to cross hedge its exposure to fly fuel by buying crude oil futures all things considered. Even however crude oil and stream fuel are two distinct commodities, they are exceptionally related. In this manner, they will probably function satisfactorily as a hedge. In any case, that's what the risk stays assuming the price of these commodities wanders essentially during the term of the contract, the airline company's fuel exposure will be left unhedged.

Cross Hedge Example

Assume you are the owner of a network of gold mines. Your company holds substantial amounts of gold in inventory, which will eventually be sold to create revenue. Accordingly, your company's profitability is straightforwardly tied to the price of gold.

According to your observations, you estimate that your company can keep up with profitability provided that the spot price of gold doesn't dip below $1,300 per ounce. Currently, the spot price is floating around $1,500. In any case, you have seen large swings in gold prices before and are anxious to hedge the risk that prices decline from now on.

To achieve this, you set out to sell a series of gold futures contracts adequate to cover your existing inventory of gold, notwithstanding your next year's production. Be that as it may, you can't find the gold futures contracts you really want. In this way, you are forced to start a cross hedge position by selling futures contracts in platinum, which is profoundly related with gold.

To make your cross hedge position, you sell a quantity of platinum futures contracts adequate to match the value of the gold you are attempting to hedge against. As the seller of the platinum futures contracts, you are resolving to deliver a predefined amount of platinum at the date when the contract develops. In exchange, you will receive a predefined amount of money on that equivalent maturity date.

The amount of money you will receive from your platinum contracts is generally equivalent to the current value of your gold holdings. In this manner, as long as gold prices keep on being firmly related with platinum, you are actually "locking in" the present price of gold and protecting your margin.

In any case, in embracing a cross hedge position, you are accepting the risk that gold and platinum prices could separate before the maturity date of your contracts. In the event that this occurs, you will be forced to buy platinum at a higher price than you anticipated to satisfy your contracts.

Features

• Cross hedges are made conceivable by derivative products, like commodity futures.
• A cross hedge is utilized to oversee risk by investing in two decidedly corresponded securities that have comparable price developments.
• Albeit the two securities are not indistinguishable, they have sufficient correlation to make a hedged position, giving prices move in a similar course.