What Is a Cross Hedge?
The term "cross hedge" refers to the practice of hedging risk using two distinct assets with positively 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, causing the position to become unhedged.
- A cross hedge is used to manage risk by investing in two positively correlated securities that have similar price movements.
- Although the two securities are not identical, they have enough correlation to create a hedged position, providing prices move in the same direction.
- Cross hedges are made possible by derivative products, such as commodity futures.
Understanding Cross Hedges
Cross hedging is made possible by derivative products, such as commodity futures. By using commodity futures markets, traders can buy and sell contracts for delivery of commodities at a specified future time. This market can be invaluable for companies that hold large amounts of commodities in 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 fluctuate rapidly in a way that erodes their profit margin. To mitigate this risk, companies adopt hedging strategies whereby they can lock in a price for their commodities that allows them to make a profit.
For example, jet fuel is a major expense for airline companies. If the price of jet fuel rises sufficiently quickly, 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, effectively paying a price today for their future fuel needs. This allows them to ensure that their margins will be maintained, no matter 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 forced to implement a cross hedge whereby they use the closest alternative asset available. In keeping with our previous example, our airline might be forced to cross hedge its exposure to jet fuel by buying crude oil futures instead. Even though crude oil and jet fuel are two different commodities, they are highly correlated and will therefore likely function adequately as a hedge. However, the risk remains that if the price of these commodities diverges significantly during the term of the contract, the airline company’s fuel exposure will be left unhedged.
Real World Example of a Cross Hedge
Suppose you are the owner of a network of gold mines. Your company holds substantial amounts of gold in inventory, which you eventually sell 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 spot price is hovering around $1,500, but you have seen large swings in gold prices before and are eager to hedge the risk that prices decline in the 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 and are therefore 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 match 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 date 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, 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 higher price than you anticipated in order to fulfill your contracts.