Cross-hedging is an investment strategy that involves hedging some type of cash commodity by making use of a futures contract. The futures contract must be on some type of related commodity rather than another cash commodity. In addition, both the commodity and the futures contract markets involved must demonstrate a similar pattern with current price trends.
In order to understand how cross-hedging works, it is first necessary to grasp the process of hedging in general. Essentially, hedging is a means of insulating the investor from the volatility of the market place by taking a position in two different markets. While the positions will be more or less equal, they will be the opposite of each other. Hedging is created when an investment is made in a different position related to a derivatives contract to counterbalance the overall risk. Losses in one market are offset by the gains in another market, thus minimizing the overall degree of risk to the investor.
Cross-hedging builds on the same idea by adding the element of making sure the two investments have some type of relation to one another, while still being totally different. For example, peanut oil may be hedged by taking a futures position involving olive oil. In the event that peanut oil begins to falter, there is a good chance that the olive oil will remain strong and may even begin to experience an upswing in market value. As a result, the investor may lose money on the peanut oil cash commodity, but the performance of the olive oil futures helps to offset the loss.
In order for cross-hedging to work, it is imperative to make sure there is some type of logical connection between the two separate investment opportunities. Without some type of correlation, the two investments are nothing more than two investments. The performance of one is not likely to impact the performance of the other. As a result, the investor may have two perfectly good investments, but is more exposed to market volatility because there is no reason for a decrease in one to possibly trigger an increase with the other investment.
Cross-hedging helps to create a safety net for investors. While determining how to set up an effective cross-hedge situation requires careful research and consideration, the strategy represents relatively little risk and provides an appreciable amount of protection for the investor.