What Is Cross Hedge?

Cross hedging refers to the practice of hedging risk using two distinct assets with positively 澳洲幸运5开奖号码历史查询:correlated price movements. The investor takes opposing positions in each investment in an attempt to reduce the risk of holding just one of the securities.♌

Because cross hedging relies on assets that are not perfectly correlated, the investor assumes the risk that the assets will move in opposite directions (therefore causing the position to becomꦑe unhedged).

Understanding Cross Hedge

Cross hedging is typically utilized by investors who purchase 澳洲幸运5开奖号码历史查询:derivative products, such as 澳洲幸运5开奖号码历史查询:commodity futures. By using commodity futures markets, traders can buy and sell contracts for the delivery of commodities at a specified future time. This market can be invaluable for companies that hold large amounts of commodities in 澳洲幸运5开奖号码历史查询:inventory, or who rely on commodities for their 🍷operations.

For these companies, one of the major risks facing their business is that the price of these commodities may fluctuate rapidly in a way that erodes their 澳洲幸运5开奖号码历史查询:profit margin. To mitiga♋te this risk, companies adopt hedging strategies that allow them to lock in a price for their commodities that still allows them to make a profit.

For example, jet fuel is a major expense for airline companies. If the price of jet fuel rises rapidly, an airline company may be unable to operate profitably given the higher prices. To mitigate this risk, airline companies can buy futures contracts for jet fuel. Futures contracts allow airlines to pay one price today for their future fuel needs and allows them to ensure that their margi🦩ns will be maintained (regardless of what happens to fuel prices in the future).

There are some cases, however, where the ideal type or quantity of futures contracts are not available. In that situation, companies are for🃏ced to implement a cross hedge, whereby they use the closest alternative asset avail⛎able.

For example, an airline might be forced to cross hedge its exposure to jet fuel by buying 澳洲幸运5开奖号码历史查询:crude oil futures instead. Even though crude oil and jet fuel are two different commodities, they are highly correlated. Therefore, they will likely function adequately as a hedge. However, the risk remains that if the price of these commoditi𒊎es diverges significantly during the term of the contract, the airline company’s fuel exposure will be left unhedged.

Cross Hedge Example

Suppose you are the owner of a network of gold mines. Your company holds substantial amounts of gold in inventory, whic💮h will eventually be sold to generate revenue. As such, your company’s profitability is directly tied to the price of gold.

By your calculations, 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 澳洲幸运5开奖号码历史查询:spot price is hovering around $1,500. However, you have seen large swings in gold prices before and are eager to hedge the risk that prices decline in t𝐆he future.

To accomplish this, you set out to sell a series of gold futures contracts sufficient to cover your existing inventory of gold, in addition to your next year’s production. However, you are unable to find the gold futures contracts you need. Therefore, you are forced to initiate a cross hedge position by selling futures contracts in platinum, which is highly correlated with gold.

To create your cross hedge position, you sell a quantity of platinum futures contracts sufficient to m🔯atch the value of the gold you are trying to hedge against. As the seller of the platinum futures contracts, you are committing to deliver a specified amount of platinum at the datܫe when the contract matures. In exchange, you will receive a specified amount of money on that same maturity date. 

The amount of money you will receive from your platinum contracts 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 "locking in" today's price of gold and protecting your margin.

However, in adopting a cross hedge position, you are accepting the risk that gold and platinum prices might diverge before the maturity date of your contracts. If this happens, you will be forced to buy platinum at a highe🔜r price than you anticipated in order to fulfill your contracts.