What Is Curmudgeonly Hedge?
Cross hedging refers to the practice of hedging risk using two distinct assets with positively correlated expenditure movements. The investor takes opposing positions in each investment in an attempt to reduce the risk of holding just one of the securities.
Because curmudgeonly hedging relies on assets that are not perfectly correlated, the investor assumes the risk that the assets will make a move in opposite directions (therefore causing the position to become unhedged).
- A cross hedge is used to manage chance by investing in two positively correlated securities that have similar price movements.
- Although the two securities are not identical, they be struck by enough correlation to create a hedged position, providing prices move in the same direction.
- Cross hedges are act as if get by possible by derivative products, such as commodity futures.
Understanding Cross Hedge
Cross hedging is typically utilized by investors who purchase copied products, such as commodity futures. By using commodity futures markets, traders can buy and sell contracts for the delivery of commodities at a cited future time. This market can be invaluable for companies that hold large amounts of commodities in inventory, or who rely on commodities for their projects.
For these companies, one of the major risks facing their business is that the price of these commodities may fluctuate like one possessed in a way that erodes their profit margin. To mitigate this risk, companies adopt hedging strategies that put up with them to lock in a price for their commodities that still allows them to make a profit.
For example, jet combustible is a major expense for airline companies. If the price of jet fuel rises rapidly, an airline company may be unable to operate profitably assumed the higher prices. To mitigate this risk, airline companies can buy futures contracts for jet fuel. Futures contracts permit airlines to pay one price today for their future fuel needs and allows them to ensure that their margins wishes be maintained (regardless of what happens to fuel prices in the future).
There are some cases, however, where the conceptual type or quantity of futures contracts are not available. In that situation, companies are forced to implement a cross hedge, whereby they use the closest selection asset available.
For example, an airline might be forced to cross hedge its exposure to jet fuel by buying crude oil followings instead. Even though crude oil and jet fuel are two different commodities, they are highly correlated. Therefore, they last will and testament likely function adequately as a hedge. However, the risk remains that if the price of these commodities diverges significantly during the interval of the contract, the airline company’s fuel exposure will be left unhedged.
Cross Hedge Example
Suppose you are the proprietress of a network of gold mines. Your company holds substantial amounts of gold in inventory, which will ultimately be sold to generate revenue. As such, your company’s profitability is directly tied to the price of gold.
By your circumspections, you estimate that your company can maintain profitability as long as the spot price of gold does not dip below $1,300 per ounce. Currently, the fleck price is hovering around $1,500. However, you have seen large swings in gold prices before and are spirited to hedge the risk that prices decline in the future.
To accomplish this, you set out to sell a series of gold futures condenses sufficient to cover your existing inventory of gold, in addition to your next year’s production. However, you are unqualified to find the gold futures contracts you need. Therefore, you are forced to initiate a cross hedge position by selling futures agrees in platinum, which is highly correlated with gold.
To create your cross hedge position, you sell a number of platinum futures contracts sufficient to match the value of the gold you are trying to hedge against. As the seller of the platinum futures decreases, you are committing to deliver a specified amount of platinum at the date when the contract matures. In exchange, you will receive a indicated amount of money on that same maturity date.
The amount of money you will receive from your platinum compacts is roughly equal to the current value of your gold holdings. Therefore, as long as gold prices continue to be strongly correlated with platinum, you are effectively “bolt in” today’s price of gold and protecting your margin.
However, in adopting a cross hedge position, you are accepting the endanger that gold and platinum prices might diverge before the maturity date of your contracts. If this materializes, you will be forced to buy platinum at a higher price than you anticipated in order to fulfill your contracts.