Cross hedging in trading is a hedging strategy using two positively correlated assets. Traders must distinguish between the “what is cross hedging” definition and the difference between cross hedging, beta, and delta hedging.
Traders must also understand the cross hedge vs. proxy hedge difference, especially in Forex. One easy way to differentiate them is that a proxy hedge requires two currencies, and the trader currency is not one of them. A cross hedge consists of three, including the trader currency.
A higher correlation results in a more efficient hedge, but the relationship is not perfect. Therefore, a trader must accept the risk that both positions move in the opposite direction.
The Cross Hedging Meaning Explained
Companies with massive inventory levels and traders with significant positions will use hedging to mitigate risk and lock in current prices when they expect a volatility rise or undesirable price action ahead.
For example, jet fuel costs remain a substantial cost for airlines, and surging prices could result in unprofitable operations. Therefore, an airline can hedge its exposure by buying jet fuel futures or enter a cross hedge by buying crude oil futures. A cross hedge presents the next alternative with a high correlation ratio if the primary hedge is unavailable.
The Difference Between Cross Hedging and Hedging
Cross hedging uses two positively correlated assets, while hedging relies on an inverse relationship. Below is an example of each one to illustrate the difference.
A cross hedging example:
- A trader has $5,000 worth of gold and hedges $2,500 by selling platinum futures, resulting in a cross hedge
A hedging example:
- A trader has $10,000 worth of individual stocks and hedges $3,500 with a short position in NASDAQ 100 futures, also known as a beta hedge
- A trader has $2,000 of stock in company XYZ and hedges $1,000 by selling options in company XYZ, also known as a delta hedge
A perfect hedge does not exist, and while a 1:100 ratio appears risk-neutral, financing costs for leveraged positions, transaction costs, and spreads will cause a 1:100 hedged position to result in a net loss.
While a cross hedge relies on correlated assets, the relationship is not 1:1. Therefore, a trader accepts the risk that both assets move in the opposite direction, breaking the hedge, increasing floating trading losses, requiring additional capital, or realizing losses.
Understanding What Is Cross Hedging with a Cross Hedging Example
The below cross hedge example helps us understand the principle of a cross hedge.
Assume the following:
- A gold mining company wants to lock in gold prices at $1,750 for 1,000,000 ounces six months out
- It cannot find gold futures at the desired price and expiration and opts to cross hedge using platinum at $740
- The correlation ratio is 0.90
- Gold volatility is at 12%
- Platinum volatility is at 20%
Therefore:
- The optimal hedge ratio is 54%
- The gold mining company should enter a cross hedge worth 540,000 ounces to achieve an optimal hedge
Noteworthy:
- Hedging 1,000,000 ounces of gold with 1,000,000 ounces of platinum would create an over hedge, as platinum is more volatile, meaning it moves more than gold
What is the Cross Hedging Formula?
A cross hedge ratio of 0 implies an unhedged portfolio, while 1 suggests a fully hedged portfolio. The hedge ratio is an essential risk management measure and shows what percentage of the portfolio may feel a negative impact should price action move in the wrong direction.
Traders may use a static or a dynamic hedge. The former remains unchanged, irrelevant to market moves, while the latter results in an adjustment to keep the ratio intact.
Here is a simple cross-hedging formula for the hedge ratio:
Hedge Ratio = Value of the Hedge / Value of the Underlying Asset
Assume the following:
- The value of the hedge is $3,500
- The value of the underlying asset is $8,500
Therefore, the hedge ratio is:
$3,500 / $8,500 = 41.18%
Since portfolios consist of numerous positions, often unrelated, especially in a well-diversified portfolio, traders should compute the optimal hedge ratio or the minimum-variance hedge ratio.
The formula for the optimal hedge ratio is:
Optimal Hedge Ratio = Correlation (between asset and hedge) x (Volatility of the Asset / Volatility of the Hedge)
Assume the following:
- Correlation is 0.85 (85%)
- The volatility of the asset is 15%
- The volatility of the hedge is 19%
Therefore, the optimal hedge ratio is:
0.85 x (15% / 19%) = 67.11%
When to Use Cross Hedging
Market participants use cross hedging when the desired asset is unavailable or thinly traded. For example, if an airline seeking to hedge jet fuel exposure cannot find jet fuel futures at the desired price, the closest alternative asset is crude oil futures. A high correlation ratio is essential for a cross hedge.
The primary cross hedging risk is that the underlying asset and the hedge become unrelated, and price action for both moves in the opposite direction. It increases losses and unhedged the position. It is impossible to eliminate all associated trading risks.
Over hedging is another risk, where the hedged position has a more significant impact than the underlying asset. A what is cross hedge in trading understanding can assist traders in risk mitigation. Skilled traders may exit both positions at a profit or close the underlying asset at a profit and hedge the hedge, but everything circles back to conducting an in-depth and accurate market analysis.
Cross Hedge Conclusion
What is cross hedging in trading is a question traders must be able to answer. A cross hedge uses two assets with a high correlation to hedge a position, but a cross hedge in Forex consists of three currency pairs. A Forex cross hedge can offer exposure to thinly traded markets. Traders can lower the risk of their cross hedge by ensuring a high correlation but cannot eliminate all risks.
The correlation between both assets of a cross hedge determines how much of a hedge the trader must add to a portfolio to achieve the desired hedge ratio. Calculating the optimal hedge ratio and deciding between a static or dynamic hedge are vital components of risk management.
FAQs
What percentage should you hedge?
It depends on individual preferences and risk profiles. For example, if a portfolio manager believes short-term market fluctuations will result in a 10% downside before resuming an uptrend, a 1:10 hedge makes sense.
Is hedging risk-free?
Hedging is not risk-free, as it lowers the overall profit potential, given the inverse correlation between the original position and the hedge. For example, buying individual S&P500 components and shorting the S&P500 will lower risk but offset profitability, dependent on the hedge ratio.
Is hedge ratio alpha or beta?
The hedge ratio is beta, meaning the hedge ratio of open positions concerning the market. For example, if the market beta is 0.9, a trader would sell $900 worth of equities for every $1,000 in long positions.
What is delta hedging?
Delta hedging uses options to lower the directional price action of the underlying asset. For example, hedging a position in gold be with gold options. It differs from beta hedging, which relies on inversely correlated assets to hedge a portfolio.
