What is a 'Natural Hedge'

A natural hedge is the reduction in risk by institutions that are exposed to large swings in exchange rates by exploiting their normal operating procedures. This can include receiving income in another country and currency while incurring expenses in that same currency. The cash flows would not be subject to exchange rate fluctuations.

BREAKING DOWN 'Natural Hedge'

Unlike other types of hedges, a natural hedge does not require the use of sophisticated financial products such as forwards or derivatives. However, most hedges (natural or otherwise) are imperfect, and usually do not eliminate risk completely.

Examples of a Natural Hedge

A company with significant sales in one country holds a natural hedge on its currency risk if it also generates expenses in that currency. For example, an oil producer with refining operations in the US is (partially) naturally hedged against the cost of crude oil, which is denominated in U.S. dollars. While a company can alter its operational behavior to take advantage of a natural hedge, such hedges are less flexible than financial hedges.

Natural hedges also occur when a business's structure protects it from exchange rate movements. For example, when suppliers, production, and customers are all operating in the same currency, large companies may look to source raw materials, components, and other production inputs in the final consumer's country. The business can then set costs and price in the same currency.

For financial companies, such as mutual fund management, and depending on the inflation/deflation condition in the economy, Treasury bonds and notes can be a natural hedge against stock price movements. This is because bonds tend to perform well when stocks are performing poorly and vice versa. Bonds are considered to be "risk off" or safety assets while stocks are considered to be "risk on" or aggressive assets. It is important to know if the bond/stock relationship is actually in this condition before hedging. In the years after the 2008 financial crisis, bonds and stocks were both in strong bull markets so the hedge would not have worked.

Pairs trading is another type of natural hedge. This involves buying long and short positions in highly correlated stocks because the performance of one will offset the performance of the other.

Using Futures as a Natural Hedge

To supplement natural hedging, companies can still use financial instruments such as futures. This includes locking in a price to buy or sell commodities for a later date. For some companies, from farming to oil drilling to lumber, shifting as much of their operations to the country where they plan to sell their goods can help reduce currency risk.

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