What Is a Natural Hedge?
Let me explain what a natural hedge is: it's a management strategy where you mitigate risk by investing in assets that naturally perform in opposite ways. For example, if you own financial stocks, holding bonds can act as a natural hedge because interest rate changes often affect them inversely.
You can also implement a natural hedge through your normal operating procedures. Say your revenues and expenses are in the same currency; that setup naturally reduces your exposure to exchange rate risks.
Key Takeaways
Understand that a natural hedge aims to cut risk by using assets with negative correlations via some built-in mechanism. Within a company, it can happen when losses in one area are balanced by gains in another. Importantly, unlike standard hedging, this approach skips complex tools like forwards or derivatives.
Understanding Natural Hedges
A natural hedge means using asset classes that historically show opposite performances in certain economic conditions to lower overall risk for your portfolio or company. The core idea is that by putting resources into two different classes, the risk from one gets offset by the other's returns, and vice versa.
In essence, the cash flows from one cancel out those from the other, achieving the hedge. If your company has big sales in one country, you're exposed to currency risk when bringing that money back. You can cut this risk by moving operations there and incurring expenses in the same foreign currency—that's a natural hedge in action.
Take an oil producer with U.S. refining operations: it's naturally hedged against crude oil costs, which are in U.S. dollars. While you can adjust operations for such a hedge, it's less flexible than financial ones.
Special Considerations
Unlike other hedging methods, a natural hedge doesn't need advanced financial products like forwards or derivatives. That said, you can still add instruments like futures to boost your natural hedges.
For instance, a commodity company might move operations to the sales country for a natural currency hedge, then use futures to fix the product's selling price later. Remember, most hedges—natural or not—are imperfect and don't wipe out all risk, but they're successful if they slash a big chunk of it.
Other Examples of Natural Hedges
Natural hedges can arise from a business structure that shields against exchange rate shifts. If suppliers, production, and customers all use the same currency, large companies might source materials in the consumer's country, setting costs and prices in that currency.
For mutual fund managers, treasury bonds and notes serve as a natural hedge against stock movements, since bonds often do well when stocks falter, and the reverse. Bonds are 'risk-off' assets, stocks 'risk-on,' but this negative correlation isn't always reliable—post-2008, they sometimes moved together, making the hedge ineffective.
Pairs trading is another form: you take long and short positions in highly correlated stocks, so one's performance offsets the other's.
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