Lesson 8 of 8
There are cases where it is not possible to find futures contracts on a particular underlying in order to hedge the exposure to the commodity. In this case futures on the nearest underlying will be used to perform the hedge and this process is known as cross-hedging. Some of the reasons there are problems in cross hedging commodities are due to mismatch in:
The question then arises as to which contract should be chosen for the cross-hedging purposes. The answer is that the contract whose prices are highly correlated with that of the underlying asset needs to be used for the hedging. It is very important for this contract to be liquid in nature and the delivery month should be the same or just after the hedge will be lifted.
In a cross hedge there is always basis risk i.e. the risk that prices of the spot and the futures will merge together as the futures nears expiry.
The most common reason why cross-hedging happens is because of the inability to find contracts on the same underlying whose risk needs to be hedged in any of the exchanges. Also this happens when the liquidity of these contracts is not really that great.
A classic example of cross-hedging is in case of West-Texas crude oil future contracts which only trade on those markets so they can only provide as an imperfect hedge for oil that is traded in a different region or of a different grade.
It is also very difficult to find futures contract for Jet fuel so airlines that wish to hedge the price exposure will resort to using crude oil or gasoline futures instead. Although the prices of these commodities are not perfectly correlated with each other so the hedge will never take place for all of the risk rather it will address only much of the risk.
The remaining risk is called the basis risk which is defined as the spot price of the asset minus the futures price. If the asset and the futures contract on that asset are similar then there is no basis risk at all i.e. the basis will go to zero when the contract expires. However, if there is a mismatch the basis will never go to zero so there is always some residual risk.