Cross hedging challenges: overview and application.

Abstract

A common problem that affects companies worldwide is the management of price risk. This work aims at analysing the strategies that risk managers can implement in order to deal with this problem. The major instrument available for hedging purposes is derivative contracts. A derivative contract is a financial instrument whose value depends on the value of an underlying variable, for example, an asset. In the last 40 years, derivatives have always assumed a more important role in finance. Derivative markets have been developing fast, offering an increasing number of different derivative contracts. In an ideal world, corporate hedgers should be able to trade a derivative contract for each asset whose price is a risk source for the firm. However, many real-world examples show that this is not the usual framework. It may happen that the hedging strategy requires the derivative contract used to be closed out earlier than the natural expiring date, that firms do not know when the risky transaction will arise or that the asset to hedge has no futures markets. When a hedger finds itself in one of these cases, it might try to build a hedging strategy using a derivative contract whose underlying asset is different to the one being hedged. A hedging strategy of this type is known as a cross hedging strategy, on which this thesis is dedicated.