Cross hedging vs proxy hedging

CFA Level III
#1

Hi,

I am reading the definitions in the Schweser notes and in the curriculum but I still struggling with those concepts…

Could you please explain to me in a simple way?

Thanks

Snah

#2

I screwed this up in a mock this morning.

Proxy = use a currency that is correlated to the one you are trying to hedge

Use USD/MXN rather than USD/Guatemala because MXN is correlated with Guatemala but the pair is more efficiently priced

Cross = using 2 different currency pairs to hedge because a direct is not available or is inefficient

Example: instead of using USD/Kenya you could use USD/Egypt and Egypt/Kenya

#3

@analystdude

Proxy hedge is not an exact hedge.

How about cross hedge?

#4

The way I see it: If you are an American (domestic), investing in Europe (foreign market)…

Proxy Hedge: Hedge using the Pound (UK/USD), because it is highly correlated with the Euro (EUR/USD) - therefore hedge using different foreign market and domestic

Cross Hedge: Hedge using EUR/CAN (Canadian dollar - so you hedge foreign market with non-domestic currency)

That’s the way I see it from Reading 22 in CFAI

#5

On cross I am going from a Schweser explanation and a diagram they had in a mock, they describe it as building a bridge across the 3 currencies. Either way, just know that cross involves 3 currencies including the investor’s and proxy only has 2, and the investor’s is not one of them

#6

I am not sure, I would think no but I am sure someone can answer

#7

  • Forward Hedge - Hedging using the Bond’s Currency and the Home Currency

  • Proxy Hedge - Hedging using a currency that is highly correlated with the Bond’s Currency and the Home Currency.

  • Cross Hedge - Hedging using the two different currencies (one usually being the Bond’s Currency) not highly correlated with the Home Currency. This is used in the case were the PM believes the different currency will depreciate less than the Bond’s Currency and usually represents less volatility.

  • Mean-Variance Hedge is a Cross Hedge aimed at minimizing volatility in returns. All MVHs are Cross Hedges but not all Cross Hedges are MVHs.

#8

I also use the acronym F PH CO2 to remember this. PH - Proxy and Highly Correlated and CO2 - Cross other 2 two currencies.

#9

Is this a correct example of cross hedge?? I am a Thai investor who invests in Korea. THB/KWN is not actively traded so i hedge Korean exchange rate risk using KWN/USD and then convert USD into THB using THB/USD

#10

Yes it is. If you would have used renminbi yuan instead THB to hedge KWN measured exchange exposure, you would use proxy and proxy would be renminbi.

PS

Maybe is not good example with renminbi in this case but I’m not familiar with those currencies.

#11

Right, Thank you!