Natural hedge definition
/What is a Natural Hedge?
A natural hedge is a risk mitigation technique that involves investing in asset pairings that are negatively correlated. Natural hedges also occur through the normal course of business; for example, a company that conducts operations in another country will have minimal currency risk, because cash inflows and outflows are in the same currency. This means that a firm might set up supply chains within the country in which it produces and sells goods, so that currency risk is largely avoided. Otherwise, if it only sold into that country but had operations elsewhere, then it would be exposed to currency risk when repatriating the cash back to corporate headquarters.
Natural hedges are designed to be relatively simple to operate, without much financial manipulation. Instead, the business is structured to minimize risks, reducing the need for derivatives and other exotic financial products. However, natural hedges rarely eliminate all of the risk, so some additional hedging is usually needed to minimize the total risk level to which a business is subjected. Nonetheless, the use of natural hedges can greatly reduce the cost of the derivatives that a business must purchase in order to cover its financial risks.
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How to Set Up a Natural Hedge
The essential approach to natural hedging is to find asset classes that react differently to an economic situation, so that changes in their cash flows offset each other. In short, if an economic event triggers an increase in cash flow from one asset class, then it should trigger negative cash flow in the other asset class, so that the two sets of cash flows cancel each other out.
Examples of Natural Hedges
Here are several examples of natural hedges with descriptions:
Local supply chains for exporters. A U.S.-based manufacturer that exports to Canada sources raw materials from Canadian suppliers and pays in Canadian dollars. Since sales and costs are in the same currency, this setup naturally offsets the risk of currency fluctuations.
Regional manufacturing and sales. A European carmaker produces vehicles in the UK and sells them primarily to UK customers. By aligning production costs and sales revenue in British pounds, the company minimizes exchange rate risk.
Offshore revenue and debt. A company with significant revenue in Japan borrows in Japanese yen. Revenue earned in yen can be used to repay the yen-denominated debt, reducing the risk of currency fluctuations.
Commodities extraction and sales. An oil producer that both extracts and sells oil in the U.S. faces minimal exchange rate risk since costs and revenues are in U.S. dollars, providing a natural hedge against currency volatility.
Cost and revenue matching for airlines. An airline that generates revenue in euros but also leases planes and buys fuel in euros reduces currency risk, as both income and expenses are aligned.
Local sourcing for retailers. A European fashion retailer that sources clothing from manufacturers within the EU and sells to EU customers avoids exchange rate risk by keeping both expenses and revenues in euros.
Tourism and local expenses. A hotel in Thailand that earns revenue in Thai baht and sources supplies locally also in baht avoids exchange rate risks. This natural hedge aligns costs and revenues in the same currency.
Agricultural production and sales. A Brazilian coffee exporter paying local farmers in Brazilian reais and earning revenues in reais from domestic sales avoids currency risk, as both inflows and outflows match.
Foreign subsidiary operations. A U.S.-based tech company with a subsidiary in India pays its Indian employees and suppliers in rupees while generating local revenue in rupees. This naturally hedges against U.S. dollar and rupee exchange rate risk.
Balanced currency revenue streams. A multinational company earning half of its revenue in euros and the other half in U.S. dollars, while also incurring costs in both currencies, benefits from a natural hedge by balancing its exposure to currency movements.