What is Cross Hedge?

Cross hedging refers to the practice of hedging risk using two distinct assets with positively correlated price movements. The investor takes opposing positions in each investment in an attempt to reduce the risk of holding just one of the securities. Because cross hedging relies on assets that are not perfectly correlated, the investor assumes the risk that the assets will move in opposite directions (therefore causing the position to become unhedged).

Cross hedging is typically utilized by investors who purchase derivative products, such as commodity futures. By using commodity futures markets, traders can buy and sell contracts for the delivery of commodities at a specified future time. This market can be invaluable for companies that hold large amounts of commodities in inventory, or who rely on commodities for their operations.

For these companies, one of the major risks facing their business is that the price of these commodities may fluctuate rapidly in a way that erodes their profit margin. To mitigate this risk, companies adopt hedging strategies that allow them to lock in a price for their commodities that still allows them to make a profit.

Cross Hedge Example

Suppose you are the owner of a network of gold mines. Your company holds substantial amounts of gold in inventory, which will eventually be sold to generate revenue. As such, your company’s profitability is directly tied to the price of gold. By your calculations, you estimate that your company can maintain profitability as long as the spot price of gold does not dip below $1,300 per ounce. Currently, the spot price is hovering around $1,500. However, you have seen large swings in gold prices before and are eager to hedge the risk that prices decline in the future.

To accomplish this, you set out to sell a series of gold futures contracts sufficient to cover your existing inventory of gold, in addition to your next year’s production. However, you are unable to find the gold futures contracts you need. Therefore, you are forced to initiate a cross hedge position by selling futures contracts in platinum, which is highly correlated with gold. To create your cross hedge position, you sell a quantity of platinum futures contracts sufficient to match the value of the gold you are trying to hedge against. As the seller of the platinum futures contracts, you are committing to deliver a specified amount of platinum at the date when the contract matures. In exchange, you will receive a specified amount of money on that same maturity date.

The amount of money you will receive from your platinum contracts is roughly equal to the current value of your gold holdings. Therefore, as long as gold prices continue to be strongly correlated with platinum, you are effectively “locking in” today’s price of gold and protecting your margin.

However, in adopting a cross hedge position, you are accepting the risk that gold and platinum prices might diverge before the maturity date of your contracts. If this happens, you will be forced to buy platinum at a higher price than you anticipated in order to fulfill your contracts.