Cross-Hedging

Hedging one instrument’s risk with a different by taking a position in a related derivatives contract. This is done when there is no derivatives contract for the instrument being hedged, or a suitable derivatives contract exists but the market is highly illiquid.

The maturity of the derivatives contract must be at least as long as the maturity of the desired hedge, otherwise the investor will be left with an unhedged exposure for a period of time.

The success of cross-hedging depends completely on how strongly correlated the instrument being hedged is with the instrument which underlies the derivatives contract. Additionally, the credit quality of the derivative and the instrument being hedged needs to be similar and their markets need to be of similar liquidity, so that price changes are similar.

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