What is the difference between the two?
From my understand, cross hedge = use another correlated currency to your “target” currency to be hedged (e.g. use CHF to hedge an EUR exposure); whereas proxy hedge = use another cross-currency hedge to hedge (e.g. use CHFEUR to hedge a GBPUSD currency exposure). Am I correct?
I always confuse the terms so I’d appreciate if someone can share how to keep the two straight.
Assume you are long CHF (live in US and will get a bunch of CHF in 3 months).
If you hedge by selling a future to deliver CHF and receive USD, that’s the normal hedge.
If you hedge by selling a future to deliver EUR and receive USD, that’s a proxy hedge.
If you hedge by selling a future to deliver CHF and receive EUR, that’s a cross hedge.
There is no scenario where you will exchange EUR and GBP to hedge a CHF and USD transaction.
(Or in your example, use CHF and EUR to hedge GBP and USD denominated transaction.)
1recho, thanks. Yes, my example with the GBP was not good, sorry for that. But I´ve understood the difference. Thanks again.
Suppose that your domestic currency is the Canadian dollar, and that you’re expecting to receive a sizable paymant in Thai bhat in three months. You’re concerned about THB/CAD exchange rate risk, but there are no actively-traded THB/CAD forward contracts. You consider two alternatives to a THB/CAD forward:
- If you’re not concerned about Thai bhat / Aussie dollar exchange rate risk (you’re pretty sure that Thai bhat and Aussie dollars have a strong, positive price correlation, or that the bhat will appreciate relative to the Aussie dollar), you could enter into a CAD/AUD forward; this is a proxy hedge : you’re using AUD as a proxy for THB.
- If you’re not concerned about the AUD/CAD exchange rate risk (you’re pretty sure that CAD and AUD have a strong, positive price correlation, or that the Aussie dollar will appreciate relative to the Canadian dollar), you could enter into a THB/AUD forward; this is a cross-hedge : you’re exchanging the THB/CAD exchange rate risk for AUD/CAD exchange rate risk.
That’s an even better explanation. I wasn’t sure what the motivation behind entering a cross hedge was.
Any tips on how NOT to confuse proxy vs cross? A cool mnemonic or some other memory device.
Mnemonic: cross = aCROSS border = i.e. it doesn´t use your local currency.
in schweser question 31 of book 1, exam 3 they refer to cross hedge even with the hedge being in the same currency as the bond. For bonds a cross hedge is different but I thought it just meant you hedged the bond you own with a future contract of another bond. That is not what they are doing but just hedging the curency using a forward of same currency as bond. So not sure why this is being called a cross hedge.
Here’s how i remember for currency Hedging:
Direct hedge: DC / FC
Proxy hedge: DC / FC’
Cross hedge: FC’ / FC
If you come across cross hedge outside of currency hedging, it has the same meaning as proxy hedge (in currency hedging). Meaning you use an asset that has high correlation with the asset you are hedging to hedge the risk.