What is cross hedging? Why does it reduce a bank’s ability to perfectly hedge against price...

What is cross hedging? Why does it reduce a bank’s ability to perfectly hedge against price risk?

Expert Solution

Cross hedging is investment strategy which is reflecting involvement of covering a financial risk arising from a certain trading position by purchasing and other financial instrument whose price action is correlated, so, variation in the former are offset by those in the later.

Banks turns to cross charging when it is unable to find contract to hedge against potential variation in the price of particular underlying asset so in these cases banks need to find a highly correlated assets for Cross hedging purpose.

Banks can not perfectly hedge against the price risk because interest rate change are subject to monetary policy changes and it is dependent upon the change in the economic structure which can never be predicted in advance and these contracts related to interest rates are not traded in the market, so, Banks cannot directly hedge without the interest rate risk and then they are going for Cross hedging.

jeff jeffy answered 2 years ago

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