What is a Cross Hedge
A cross hedge is used to manage risk by investing in two positively correlated 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. Although the two securities are not identical, they have enough correlation to create a hedged position, providing prices move in the same direction.
BREAKING DOWN Cross Hedge
The success of cross-hedging depends on how strongly correlated the hedged instrument is with the instrument underlying the derivatives contract. When using a cross hedge, the maturity of the two securities must 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.
A cross hedge is often used by traders in commodities and futures markets where it can be difficult to find a contract that hedges the exposure of a held commodity. For instance, a trader may not find a suitable contract to hedge their position in jet fuel, therefore, they may use crude oil futures as a cross hedge. (For further reading, see: How to Use Commodity Futures to Hedge.)
Purpose of Using a Cross Hedge
Using a cross hedge is a form of investment insurance that is intended to reduce risk. Hedging does not eliminate the amount of risk involved in an investment; it just softens the negative effect on the investor. 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 declines in value, the other appreciates in value.
Example of a Cross Hedge
Suppose an investor has a long position in a gold mining company, such as Newmont Mining Corp., and then takes a short position in a gold exchange-traded product (ETP), such as DB Short Gold ETN. Because the price of the gold company's stock moves in tandem with the price of gold, it creates a cross hedge. There wouldn't be a perfect correlation, so this example does not provide a perfect hedge. When using an ETP to create a cross hedge, investors need to be aware of the product’s leverage. For example, if an investor bought an inverse gold ETF with 2x leverage, it magnifies the inverse returns of the gold price by a factor of two. Incorrectly purchasing a leveraged ETP could overexpose one-half of the investor’s cross hedge. (To learn more, see: Hedging With ETFs: A Cost-Effective Alternative.)