What is a perfect hedge?
A hedge is perfect once the folowing condition is met:
Price change on the spot market (of the security you want to hedge) – Price change on the futures market ( of the contract you use for hedging) = 0
However in reality it’s hardly possible to achieve a perfect hedge. There are several reasons why that’s the case:
- Usually, there is not a complete identity between the hedged position and the available future.
- The base convergence (The tendency that spot price and future price move towards each other till maturity). This goes so far, that on the maturity date the price of the future and the spot price is the same.
- random price fluctuations (they could temporarily outweigh (disturb) the base convergence)
If one is able to find a future contract that has many identical features (currency etc.) with the opposing position, then one has the best preconditions for an efficient hedge. Then one can expect that the interest induced price swings are somewhat identical, apart from the base convergence. If the price swings are somewhat identical (apart from the base convergence) this is also called a pure hedge.
Cross hedge: If the future does not have identical features with the opposing security. Changes in interest rates lead to varying price fluctuations. Cross hedges have a higher basis risk as the fluctuations between the two instruments are higher. As there are only a few futures and many stocks there will typically be more cross hedges. One selects the contract that has the highest correlation to the hedging position.
Look there is even a picture : Basis = Price Spot Market - Price Futures Market
