Cross Hedging of Various Asset Classes is more effective than Direct Hedges : Research Study

According to a research study titled “Cross Hedging of Various Asset Classes : Review and Analysis” by Prof. Namita Sahay, Amity University, Noida, published in the recently released, Vol. XXX No. 4, December 2016 issue of Finance India-Quarterly journal of Finance published by Indian Institute of Finance, Cross hedges have been found to be more effective than direct hedges. The effectiveness of hedging is judged by finding optimal hedge ratio with different models like minimum valance model, Daily Dynamic Conditional Correlation (DCC) - GARCH, traditional cross hedging, multiplicative cross hedging & Bayesian Procedures.

Today, Cross hedging has emerged as an effective tool to reduce price risk for different classes where a direct hedge through futures market is not available.

Many studies have been conducted to explore the correlation between different asset classes like currency, commodity, stocks, and stock index, insurance and inflation derivatives and analyze the maximum risk reduction possible with different portfolios and combinations.

The paper analyzed several studies conducted on cross hedging ranging from simple currency and commodity derivatives to complex inflation and insurance derivatives. The methodology used for these studies and also the effectiveness of these techniques have been studied and analyzed. Starting from hedging major currency exposures, with a direct hedge, studies have been done on hedging even minor currencies exposures.

Studies have also shown that cross hedging has been done between foreign currency and a third currency where a triangular parity condition existed between home, foreign and third currency, since, no hedging instrument was available with the home currency.

According to the research paper, cross hedging has also been conducted on various commodities like US Hay, New Mexico Alfalfa Hay with corn futures; between fishmeal and soyabean meal and corn futures; ethanol with unleaded gasoline futures; jet fuel price risk with crude oil, Brent, WTI, heating oil and gasoil futures; winter canola with soyabean oil futures to name a few. Researchers have even explored conducting cross currency-commodity hedging in case of strong correlation between currency and commodity.

Overall, the idea has been to select an asset with a strong correlation and which ultimately reduces the hedging cost.

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