Series 3: Cross Hedge

Taken from our Series 3 Cross Hedge

A direct hedge is not always possible. A futures market does not exist for all cash instruments. We already know it no longer exists for Treasury bills. Nor can a company that issues or borrows commercial paper hedge its risk with a commercial paper futures contract. The interest rate charged for borrowing commercial paper is not tied to LIBOR. The lender or borrower must find and select some closely related instrument, such as Eurodollars, to hedge its interest rate risk.

Cross hedging is the use of a futures contract for the delivery of one security to hedge an anticipated future transaction in a different security. Cross hedges carry more basis risk than a direct hedge. Hedgers must look for a cross hedge that carries the least amount of basis risk. They must find the futures contract whose price changes are most closely aligned with the price changes of the security being hedged. This entails not only finding the right futures instrument, but the right amount of the instrument to apply.

In addition, changing interest rates affect different assets in different ways. Some securities are more price sensitive to interest rate changes than others. The proper size of the futures position will depend on the interest rate sensitivity of the underlying security as compared to that of the specific futures

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