A transaction that, as opposed to a direct hedge, involves hedging one commodity with a contract for a different commodity. An example is a crude contract hedged with a contract for natural gas liquids. This type of hedge is, by nature, an imperfect hedge, and involves in addition to price risk, the so-called basis risk. The latter risk arises because of the difference in storage requirements, which gives rise to potential arbitrage opportunities in terms of location, time and form. In the case of crude oil, there are multiple possibilities for sale: whether as crude or as processed products (gasoline, diesel, etc.)
Generally speaking, a proxy hedge may involve any two different types of assets, where the asset used as a hedge does not provide a perfect alternative for price risk mitigation.
It is also known as a dirty hedge or an indirect hedge.
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