Cross hedging is the strategy using a forward contract in a related currency correlated to the currency that we are unable to purchase a direct forward contract. Cross hedging is used as a tool to manage transaction exposure, and it requires high correlation between the two currencies to work effectively. Many minor currencies do not have forward or future contracts written for them; therefore, when doing business in these soft currencies hedging through a third currency is needed to protect the company from exchange risk. The success of this hedge strategy depends heavily on the strength of correlation between spot price and future hedge rate. Traditional “flow” theories suggest that the exchange rate reflects underlying supply and demand of currency. Changes in exchange rate directly affect changes in demand/ supply of exported/ imported goods and services; therefore, a positive correlation exists between exchange rate movement and export commodity price change. The theory also suggests that the greater world market shares for a commodity held by a country, the stronger correlation it will be in term of exchange rate, and the hedge is considered more effective. For example, Mexican peso is a more successful cross hedge for petroleum futures than Norwegian krone since Mexican peso holds about 5% the world petroleum shares while Norwegian krone only has roughly 1%. “Primary export commodity” hypothesis is another tool used to make a cross hedging successful. The hypothesis suggests that a positive relationship should exist between “export rank” and hedging effectiveness.  For example, soy bean should be a more appropriate cross hedge than coffee for Brazilian real because soy bean represents a larger portion of Brazil’s export goods. In conclusion, to measure the success of a cross hedging strategy, correlation is the key. We want a currency that is strongly positive related to our soft currency because the direction and how much the movement is will determine the exchange risk the company takes in at any changing point in time. Reference: http://proquest.umi.com.lib-proxy.fullerton.edu/pqdlink?Ver=1&Exp=05-14-...