What is Cross Hedge?
When the characteristics of the underlying position match perfectly with that of futures contract specifications, it is said as perfect hedge. A hedge that is established with either a mismatched maturity or a mismatched asset or both is referred to as a cross hedge and the risk arising from it will be called as Basis Risk.
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Cross Hedging with Asset Mismatch
- Cross Hedge refers to an investment strategy that involves covering the financial risk arising from a certain trading position by purchasing another financial instrument (Futures) which is positively correlated and has a similar price movement.
- The investor goes long on one instrument and short on the correlated instrument. Even though both the instrument is not the same, losses arising from one instrument are offset by profit in others due to their similar price movement.
- One common example of cross-hedging is the case of airlines aiming to cover their exposure to jet fuel prices. The most relevant hedging and the highly correlated option is to purchase crude oil futures contracts as jet fuel futures contracts don’t exist.
- However, these are not perfect hedges and they do not cover the company’s complete oil price risk, although they do offset much of the jet oil price volatility and minimize financial gains and losses arising from oil prices.
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Cross Hedging with Maturity and Size Mismatch
- This hedge is effective if a dollar change in the spot price is exactly offset by a dollar change in the futures price. This assumption is valid when there is no maturity or size mismatch.
- If the maturity of the futures contract mismatches, Futures hedging is known as delta hedge. If both size and maturity do not match, the hedger can go for a delta-cross hedge.
- It is a case when there is both maturity and size mismatch. In such a case, it is difficult to eliminate the basis risk.
- As a result, the futures risk is not a perfect hedge. The hedger can however go simultaneously for across hedge and a delta hedge in order to make the hedge a perfect one as far as possible.
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