What is a cross hedge?

By Chizoba Morah AAA
A:

Cross hedging is when you hedge a position by investing in two positively correlated securities or securities that have similar price movements. The investor takes opposing positions in each investment in an attempt to reduce the risk of holding just one of the securities. The success of cross-hedging depends completely on how strongly correlated the instrument being hedged is with the instrument underlying the derivatives contract. When cross hedging, the maturity of the two securities has to be equal. In other words, you cannot hedge a long-term instrument with a short-term security. Both financial instruments have to have the same maturity.

Hedging is a form of investment insurance that is meant to reduce risk. Hedging does not eliminate the amount of risk involved in an investment; it just softens the negative effect on the hedger. Typically, hedging involves investing in two securities that have a negative correlation. A negative correlation means that the two securities move in opposite directions. When one security looses value, the other gains value.

For example, you could have a long position in a gold company then take a short position in a gold ETF. Because the price of the gold company's stock would move in tandem with the price of gold, it would create a cross hedge. There wouldn't be a perfect correlation, so this example would not provide a perfect hedge.

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