What is a Cross Hedge?

Cross hedging refers to the concept of protecting one asset's value by taking a position in another, different, but closely related asset. This is a particularly useful strategy when a direct hedging instrument for the desired asset is not available. A good example are commodities futures markets where futures contracts may be illiquid or unavailable.

However, cross hedging introduces basis risk, the danger that the two assets may diverge unexpectedly, so ongoing monitoring and risk assessment are essential.

Understanding Cross Hedging

Cross hedging is a risk management technique that uses two correlated instruments to mitigate risk. It is often used by investors who purchase derivative products, such as commodity futures.

Commodity futures are powerful tools for hedging risk or seeking returns tied to the global movement of raw materials. Futures contracts are common in industries like agriculture, energy and metal, where the prices of commodities can vary dramatically in short periods of time. They are often used in cross hedging strategies.

For example, a utility company might try to hedge the risk of fluctuating electricity prices by purchasing natural gas futures contracts. This is considered a cross hedge because electricity and natural gas are two different assets, but their movements in the markets are closely linked, and a hedged position in natural gas will result in less risk for the company.

Cross hedging is particularly practical in developing markets or for less common commodities, where derivative products may not exist at all.

Basis risk

When cross hedging, there is always a chance that the price of a hedging instrument will not move in line with the price of the asset being hedged. If this happens, the hedge won't fully offset the gain or loss, leaving the investor partially unprotected. The residual risk is called basis risk.

For example, manufacturing companies that use gold often cross hedge gold prices with platinum futures, as the movement of platinum prices generally aligns with the gold market. However, if a sudden surge in demand for gold drives gold prices up 15% but platinum only rises 5%, the 10% gap will leave the company underhedged.

Key Differences Between Cross Hedging and Traditional Hedging 

The main difference between cross hedging and traditional hedging is the nature of the asset. While cross hedging involves using two correlated assets which are different from each other, traditional hedging more commonly involves taking positions in the same asset or an opposite position in an inversely correlated instrument. 

Choosing your strategy will depend on whether an available matching derivative for your instrument exists, and on the hedging effectiveness of cross hedging or traditional hedging for your asset.

Calculating the Cross Hedging Ratio 

The cross-hedging ratio is a key metric used to decide how much of a hedging instrument should be used to offset risk in an underlying asset. It is a way of calculating how many units you need to purchase to hedge your risk when working with correlated assets.

There are two main methods to calculate the hedge ratio in a cross hedge:

The simple hedge ratio formula

Hedge ratio=value of position held/value of hedge instrument

This is a useful method when the assets are very closely related, and volatility and correlation differences are not significant.

The Optimal Hedge Ratio Statistical Model

Optimal hedge Ratio=Correlation (between asset and hedge) x (Volatility of the Asset / Volatility of the Hedge)

The optimal hedge ratio is a more precise method. It is often used in institutional hedging and commodities trading because it adjusts for both volatility and correlation strength.

Types of Cross Hedge

Cross hedging is used across different financial markets. The main difference between the types of cross hedging is based on whether the hedge offsets risks related to commodities, currencies, broader market indices or another type of asset.

Commodities

A commodities-based cross hedge is commonly used when a direct hedge for a raw material or product, such as futures contracts, is unavailable within the commodity markets. A hedged position in a related commodity with a strong price relationship to the product is used instead as a risk management strategy.

Currencies

A currency-based cross hedge is employed when directly hedging a particular currency is either unavailable or not feasible. This approach is often used in international trade and investment, where companies and investors need to manage foreign exchange risk.

For example, a Japanese construction company is involved in an infrastructure project in India and expects to receive payments in Indian rupees (INR) over the next nine months. They are concerned about potential rupee depreciation, which would reduce the yen-equivalent value of their future earnings.

Because the INR/JPY derivatives market is limited, the firm decides to use Singapore dollar futures (SGD) to hedge. This works because there is a positive correlation between INR and SGD movements against JPY, and SGD/JPY futures are more liquid and accessible. This is a currency-based cross hedge.

Indices

An index-based cross hedge refers to investors using broad market indices or sector-specific ETFs to mitigate risk when they want to hedge exposure to a specific sector or desired asset but don't have a direct hedging instrument. This happens often in equity markets, where individual stocks may not have liquid options or futures contracts.

Use Cases and Examples 

Imagine you own a commercial bakery, a business that relies heavily on wheat flour to make its products. Since wheat is a key input cost, price fluctuations in the wheat market can significantly affect the bakery’s profit margins, so you decide to buy wheat futures to lock in today's wheat prices as a risk management tool, reducing price risk. However, the wheat futures contract you need isn’t available in the right volume or delivery region, which can sometimes happen with agricultural commodities.

Instead of using wheat futures directly, you decide to cross hedge using other commodities. You choose corn futures because wheat and corn are closely correlated, meaning they often move in similar directions in response to weather, crop yields, and global demand.

If wheat prices rise, corn prices will likely rise as well, so the gain on corn futures helps offset the higher wheat costs. If prices fall, the bakery may lose on its hedge but save on the wheat purchase, keeping costs relatively stable.

Other Examples

Other common examples might include a gold mining company hedging against gold prices with the closest alternative asset such as platinum futures contracts, or an airline company hedging its exposure to jet fuel by buying crude oil futures. Even though jet fuel and crude oil are two different commodities, they are closely correlated assets.

Ready to start cross hedging?

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FAQs

How does cross hedging differ from traditional hedging?

Traditional hedging involves taking a position in the same asset or using derivatives on the same asset class. Cross hedging is a risk management strategy that uses two different assets with a correlation relationship.

Can cross hedging completely eliminate risk? 

Cross hedging uses a highly correlated but not identical asset to manage exposure. While it can reduce risk significantly, it cannot neutralize it entirely due to basis risk.

Basis risk refers to the possibility that the price of the hedge instrument and the price of the asset being hedged won’t move in perfect sync. Using the bakery example from above, even though wheat and corn have a high degree of correlation, wheat prices could spike due to a crop-specific issue while corn prices remain stable, leaving the bakery unprotected from risk.

Cross hedging reduces risk but doesn't completely eliminate it, because there is no such thing as a perfect hedge.

What factors should be considered when choosing assets for cross hedging? 

When choosing assets for cross hedging, there are a few factors to consider: the correlation between asset prices, making sure that the prices of both assets exhibit a strong and stable historical relationship, the relative volatility of both the asset and the hedging instrument, and other risk factors such as economic or supply chain links, maturity and delivery terms if dealing with futures markets and historical effectiveness of the cross hedge.

Therefore, it is useful to calculate the cross-hedge ratio or the optimal hedge ratio to better understand the risk involved before deciding whether cross hedging two different assets is a good investment.

Can cross hedging be applied to other financial instruments beyond futures contracts?

Yes, cross hedging isn’t limited to futures contracts or commodities hedging. It can also be implemented using a range of financial instruments such as options, swaps and other securities. Its flexibility makes it a powerful and adaptable strategy for managing risk across diverse market environments.

For comprehensive market reports and expert analysis on commodities and financial markets to support informed investment decisions, consider the StoneX Essential Bundle.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.