What is a Natural Hedge?
A natural hedge refers to a strategy that reduces financial risks in the normal operation of an institution. It is typically done by investing in different assets and financial instruments with negative correlations among them. The conventional financial hedging strategy usually contains derivatives and forwards. The natural hedging strategy does not require sophisticated financial instruments.
- A natural hedge refers to a strategy that reduces financial risks in the normal operation of an institution.
- Natural hedges are often used for currency risks in business operations, including revenues and costs matching, re-invoicing centers, and multi-currency loan facilities.
- Compared with financial hedges, natural hedges are less costly, but they are also less flexible.
Natural Hedge in Business Operations
The key to natural hedges is to allocate resources to negatively correlated assets that perform oppositely in an economic climate. The gain from one asset (or operational behavior) should be able to roughly offset the loss from another so that the portfolio or company’s risk is naturally hedged.
Companies that sell their products in foreign markets typically face currency risks. The risk can be hedged by incurring expenses in the same currency. Such a natural hedge strategy is less costly and much easier to implement than hedging with derivatives or forwards. However, hedging by adjusting operational procedures is less flexible and less effective, as the value and timing of incomes and expenses might be very different.
Another natural hedge method for currency risk is to borrow in the same foreign currency. For example, a U.S. company sells its products in Japan and collects its revenue in JPY. It will face a foreign exchange loss if JPY devalues relative to USD. To hedge the risk, the company can borrow money around the amount of estimated revenue in JPY.
If JPY appreciates in the future, the company will generate a foreign exchange gain by receiving revenues in JPY but a loss by repaying its JPY-denominated debt. If JPY depreciates, the company will experience a loss from its sales in Japan and a gain by repaying in cheaper JPY. In both scenarios, the gain and loss can approximately offset so that the company holds a natural hedge against its currency risk.
Natural Hedge in Portfolio Management
To hold a natural hedge for the downside risk of a portfolio, a portfolio manager can balance the holding of assets with negative correlations. The negatively correlated assets generate opposite performances most of the time. A portfolio manager needs to analyze the historical performances of assets to look for the ones with negative correlations.
In general, the bond and equity market perform oppositely. A portfolio can be naturally hedged by holding both bonds and stocks in appropriate amounts. When the stock market tumbles, the loss from stocks can be partially offset by the gain from bonds, and vice versa. However, even two negatively correlated assets may lose simultaneously in extreme cases. In the 2008 Global Financial Crisis, both the stock and debt market were badly hurt.
Pairs trading, as a market-neutral arbitrage strategy, can also be used to create natural hedges for portfolios. In the pairs trading method, a portfolio holds long and short positions in two highly correlated assets. As the values of the assets move in the same direction, the opposite positions create gains and losses that can offset each other.
Asset allocation is essential to natural hedges in portfolios. A portfolio manager needs to carefully determine the ratio of the assets to hold by analyzing their correlations. Also, assets with positive (negative) correlations do not always move in the same (opposite) directions. The hedge is not always effective.
Natural Hedges vs. Financial Hedges
Unlike financial hedges, natural hedges do not require the implementation of complex financial derivatives. For example, the natural hedge strategies for currency risk include revenues and costs matching, re-invoicing centers, and multi-currency loan facilities, while the financial hedge strategies include the use of future, forward, or option packages, and cross-currency interest rate swaps.
Both types of hedges can lead to lower profitability. The return is reduced simultaneously as the risk is lowered. Also, the hedging process itself incurs cost. However, natural hedges are much cheaper than financial hedges that require buying and selling sophisticated financial instruments.
The disadvantage of natural hedges is that they are less flexible than financial hedges. A company needs to change its normal operating procedures to reach a natural hedge. The new operation behaviors may conflict with the company’s original business strategy.
The two types of hedges can be used as complementary to each other to maximize the hedging benefit. For example, a company can match its revenues with costs in the same currency to create a natural hedge. If the company estimates that its costs are not sufficient to hedge the downside risk of its revenues, it can further hedge the rest by holding some future contracts.
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