Cross Hedge (Investments) - Explained
What is a Cross Hedge?
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Table of ContentsWhat is a Cross Hedge?How Does Cross Hedging Work?Academic Research for Currency Cross Hedge
What is a Cross Hedge?
Cross-hedging is a strategy often used by investors to manage the risk of investments. Cross involves the purchase of two similar investment instruments with similar price movements in such a way that the financial risk of one of the instruments is offset by the financial gain of the other instruments. Investors who use the cross-hedging strategy purchase two financial instruments with similar price action so that the financial risks of the former instrument can be counterbalanced by the financial returns of the latter. Investors who use this strategy purchase similar future contracts with similar price trends.
How Does Cross Hedging Work?
The rationale behind a cross hedge is that it allows an investor to occupy similar positions in two different markets. This is a unique strategy that helps investors hedge market volatility. Through cross hedging, an investor purchases two correlated financial instruments in which the overall risk or loss of one is offset by the profit earned on the other. Cross over coverage is similar to a cross hedge, it entails ensuring that two investments have a level of similarity despite that they are from two distinct markets with varying conditions. Crossover or cross hedging can also occur in businesses, this entails a business having two correlated investments that are both sensitive to market volatility in such a way that one investment gives protection to the other.
Academic Research for Currency Cross Hedge
- Hedge period length and Exante futures hedging effectiveness: The case of foreignexchange risk cross hedges, Benet, B. A. (1992). Journal of Futures Markets, 12(2), 163-175. This paper describes the empirical relationship between the length of the hedge period and its effectiveness. Longer hedges help in reducing the price risk of a spot position better as compared to the short term hedges. The longer hedging period allows the resolution of price uncertainty. The spot price tracking by the futures price hedge improves with lower uncertainty, thus the effectiveness of hedging increases. Alternatively, hedging performance tends to increase for longer hedges. This is because, for longer intervals, noise in the 2 price series must be lower. Hence, in the long run, the real economic relationship between futures and spot prices prevails.
- Cross-hedging with currency options and futures, Chang, E. C., & Wong, K. P. (2003). Journal of Financial and Quantitative Analysis, 38(3), 555-574. This article presents a model of expected utility of a multinational company encountering risk exposure of exchange rate to cash flow of foreign currency. There exist no currency derivative markets between foreign and domestic currencies. However, there are options markets and currency futures between a 3rd currency that the firm can access and domestic currency. As there holds a triangular parity condition among these 3 currencies, the options markets and currency futures still provide a beneficial avenue for the company to hedge indirectly against risk exposure of foreign exchange. This paper is an analytical overview of the optimal cross-hedging policies of a company.
- Currency hedging for international portfolios, Glen, J., & Jorion, P. (1993). The Journal of Finance, 48(5), 1865-1886. This research examines the advantages of currency hedging in global equity and bond portfolios for risk minimization and speculative motives. The authors compare the risk-return performance of international diversified portfolios with the forward contracts and without, too. From 1974-1990, forward contracts inclusion results in empirically considerable improvements in the unconditional portfolio's performance which contain bonds. The authors also implement conditional strategies in and out of sample to show improving trade-off of risk-return of international portfolios and to perform extraordinary unconditional hedging strategies.
- Cross hedging in currency forward markets, Broll, U. (1996). (No. 308). Diskussionsbeitrge: Serie II, Sonderforschungsbereich 178" Internationalisierung der Wirtschaft", Universitt Konstanz. The research has been carried out to discuss the cross-hedging performed in the currency forward markets. This paper develops a model of a global firm under uncertainty of the exchange rate in a risk management framework. The firm uses currencies forwards of other country having a correlation to the spot exchange rate. This way, the risk exchange rate is cross-hedged by the firm. This paper investigates, how to imply the risk of hedging is the exchange rate of currencies less common for an exporting firm.
- Using derivatives in major currencies for crosshedging currency risks in Asian emergency markets, Aggarwal, R., & Demaskey, A. L. (1997). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 17(7), 781-796. This paper throws light on the use of derivatives in main currencies for currency risks of cross-hedging in the emergency-markets of Asia. The research states that the cross-border portfolio and direct investments keep increasing at a faster speed as compared to the international economic output, thus keeps growing in importance. Particularly, the foreign portfolio investments proportion increases and moves to emerging markets, since they propose investments with better return/risk combinations. Though making an investment in emerging markets is mostly limited by lack of liquidity and restrictions relatively.
- Multiple currencies and hedging, Broll, U., Wong, K. P., & Zilcha, I. (1999). Economica, 66(264), 421-432. This article elaborates the concepts of hedging and multi-currencies. The authors develop a competitive exporting firms model encountering multiple currency risks. There exist no future markets for the own currency of the firm, however, they exist between 2 countries currencies to which the entire output is exported by the firm. The authors make an analytical overview of optimal cross-hedging and imply it on trade flows and production. The findings are that the cross-currency future market unbiasedness has no implications of non-random profits. In addition, there is no effect of cross-hedging opportunities availability on production. However, it affects exports.
- Foreign currencydenominated debt: An empirical examination, Kedia, S., & Mozumdar, A. (2003). The Journal of Business, 76(4), 521-546. This paper evaluates the debt insurance determinants in ten main currencies by large firms of the United States. The authors use the foreign subsidiaries fraction and tests that exploit the disaggregated nature of data. This way, strong evidence is found about the issuance of foreign currency debt by the firms for hedging their exposure at the individual currency as well as aggregate levels. It also shows that firms select currencies having low data asymmetry between foreign and domestic investors. There is no evidence regarding the effect of tax arbitrage, legal regimes or debt markets liquidity on the decision about the issuance of debt in foreign currency.
- CrossHedging of ExchangeRate Risk, Broll, U., & Eckwert, B. (1996). Review of International Economics, 4(3), 282-286. There is a popular separation theorem for currencies with highly grown forward markets. It implies that global firms totally hedge the risk of the exchange rate in case of unbiasedness of the forward markets. This study proposes a model of a risk-averse company when there is no availability of perfect hedging Instruments. Rather the company uses the forward markets of the currency of a 3rd country. This way, it can cross-hedge the risk of exchange rates. The authors show that there is no implication of full hedging by all forward markets unbiasedness, though the company has the option of hedging all the risks.
- Hedging foreign currency portfolios, Gagnon, L., Lypny, G. J., & McCurdy, T. H. (1998). Journal of Empirical Finance, 5(3), 197-220. This research investigates portfolio and dynamic effects in a hedging problem of multi-currency that brings along speculative elements for the future demand and risk-reduction. The authors model the log-differences of the relevant futures prices and combined evolution of spot portfolio returns daily in a trivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) system which allows time-changing covariability in all the elements of the system. The authors examine the hedging performance from a utility standpoint and risk minimization. The findings are that accounting for portfolio impacts in building a multi-currency hedge causes utility gains and efficiency.
- Commodity futures cross hedging of foreign exchange exposure, Benet, B. A. (1990). Journal of Futures Markets, 10(3), 287-306. How can a trader overcome foreign exchange risk in case of expected cash flow denomination in a small currency? For these currencies, there are no futures and forward markets. Some LDC countries have resolved this issue by pegging. Nowadays, several currency states allow the exchange rates to directly compete in the Dirty Float System. This paper investigates the cross-hedging issue. The author employs a number of commodity futures contracts to minimize foreign exchange exposure of small currency. He compares the results to the hedging strategy of currency futures benchmark. A hedging hypothesis is a base to constructing the tested strategies.
- Hedging foreign exchange risk with currency futures: Portfolio effects, Lypny, G. J. (1988). Journal of Futures Markets, 8(6), 703-715. This paper finds the optimal or least-risk hedge ratios for every currency in, say an n-currency spot portfolio. It empirically measures the optimal ex-Post hedge ratios for a 2 currency spot portfolio of German marks and Canadian Dollars. The author compares the hedge ratios to the normal case in which he ignores the portfolio effects, called the Isolation Model and a model in which the hedge ratio for every currency is 1 is known as Naive Model. Findings are that, following a Naive Strategy, one can substantially reduce risk. The Isolation strategy provides marginal profits over the Naive strategy. However, the portfolio strategy is worse than Isolation and Naive strategies.
- Cross hedging with currency forward contracts, Wong, K. P. (2013). Journal of Futures Markets, 33(7), 653-674. This paper evaluates the behaviour of a competitive exporting company which exports goods to a foreign country and encounters numerous sources of uncertainty of exchange rate. Though there exist no hedging instruments between the domestic and foreign currencies, a 3rd country exists having well-grown currency forward markets that the firm can access. The author shows the optimal cross-hedging decision of the firm to depend on the extent of the currency forward markets incompleteness in the 3rd country and on the correlation framework of the random spot exchange rates. In such a situation of perfect cross-hedging, there holds the separation theorem but there may or may not hold the full-hedging theorem.