When a Futures Contract Is Used to Hedge a Position

question 42

Essay

When a futures contract is used to hedge a position where either the portfolio or the individual financial instrument is not identical to the instrument underlying the futures, it is called cross hedging. Cross hedging is common in asset/liability and portfolio management and in hedging a corporate bond issuance. Answer the below questions.
(a) Why is cross hedging common?
(b) What does it introduce?
(c) What two factors determine the effectiveness of a cross hedge?

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Definitions:

Bailment

The legal relationship established when possession, but not ownership, of personal property is transferred from one person to another under an agreement.

Bailee Compensation

The payment made to a bailee for the service of temporarily holding or storing the bailor's property.

Gratuitous Bailment

A legal relationship where one party, the bailor, temporarily transfers possession of an item to another, the bailee, without expectation of payment or benefit.

Bailee's Lien

The right of a bailee to retain possession of a bailor's property as security for unpaid charges related to the property.