What is difference between cross hedge and proxy hedge?

CFA Level III
#1

to me looks like both are same.

#2

Per the CFAI text:

“Proxy hedging involves using a forward contract between the home currency and a currency that is highly correlated with the bond’s currency”.

This is the situation where a hypothetical UK based investor (i.e. someone whose domestic currency returns are calculated in GBP) is long a USD denominated bond. To hedge the ccy risk coming from the USD bond the UK investor could sell CAD forward vs GBP.

CAD being highly correlated with USD, the argument is that this proxy hedge would effectively remove the risk coming from the USD exposure. For memorization it may be helpful to think that you are hedging by selling one currency ‘in proxy’ of another (i.e. selling CAD instead of USD).

What distinguishes a proxy from a cross hedge is that in the cross hedge you still sell a currency other than the one you are exposed to but (and here is the difference) you do NOT buy your domestic currency (i.e. the investor does not exchange CAD vs.GBP like in the proxy but sells CAD vs. - for instance - EUR).

“… cross hedging refers to hedging using TWO currencies other than the home currency…”.

Good luck, Carlo

#3

For currency hedge,

The forward hedge. The forward hedge is used to eliminate (most of ) the currency risk. Utilizing a forward hedge assumes forward contracts are available and actively traded on the foreign currency in terms of the domestic currency. If so, the manager enters a forward contract to sell the foreign currency at the current forward rate.

The proxy hedge. In a proxy hedge, the manager enters a forward contract between the domestic currency and a second foreign currency that is correlated with the first foreign currency (i.e., the currency in which the bond is denominated). Gains or losses on the forward contract are expected to at least partially offset losses or gains in the domestic return on the bond. Proxy hedges are utilized when forward contracts on the first foreign currency are not actively traded or hedging the first foreign currency is relatively expensive.

Notice that in currency hedging, the proxy hedge is what we would usually refer to as a cross hedge in other financial transactions. In other words, the manager can’t construct a hedge in the long asset, so he hedges using another, correlated asset.

The cross hedge. In a currency cross hedge, the manager enters into a contract to deliver the original foreign currency (i.e., the currency of the bond) for a third currency. Again, it is hoped that gains or losses on the forward contract will at least partially offset losses or gains in the domestic return on the bond. In other words, the manager takes steps to eliminate the currency risk of the bond by replacing it with the risk of another currency. The currency cross hedge, therefore, is a means of changing the risk exposure rather than eliminating it.

(Extract from Kaplan)

#4

So the concept of proxy hedge in currency is equal to cross hedge in stocks/ bonds?

What’s the proxy hedge in stocks/ bonds mean?

#5

Good question, i guess no proxy hedge in equity/ FI…only cross hedge.

#6

Proxy Hedge, your domestic currency is part of the trade. You end up having the domestic currency at a hedged value.

Cross Hedge, your domestic currency is not part of the trade. The foreign currency fluctuates in comparison to your domestic currency. You compensate for these fluctuations by gains/losses (smoothening effects) between the foreign currency and a third currency.

Direct Hedging, a nice night with your wife

Proxy Hedging, you’re in threesome

Cross Hedging, you go to a hooker

Avoiding international trades all together, you’re by your own.

#7

c’mon, no credit for me?

#8

Thanks Guys! understood it now.