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.

RELATED TERMS
  1. Money Market Hedge

    A money market hedge is a technique used to lock in the value ...
  2. Chinese Hedge

    A Chinese hedge is a position that looks to capitalize on mispriced ...
  3. Cross Hedge

    A cross hedge is used to manage risk by investing in two positively ...
  4. Basis Risk

    Basis risk is the risk that offsetting investments in a hedging ...
  5. Howard-D'Antonio Strategy

    Thee Howard Antonio Strategy offers investors an algorithm for ...
  6. Inflation Hedge

    An inflation hedge is an investment that is considered to provide ...
Related Articles
  1. Trading

    Hedging basics: What is a hedge?

    Hedging is a widely misunderstood strategy, but it's not as complicated as you might think.
  2. Investing

    Are Hedge Funds Chasing Performance?

    Learn why hedge funds have performed worse than the S&P 500 Index in 2016, and why they may overweight equities to play catch-up in the second half of 2016.
  3. Managing Wealth

    Is the Hedge Fund Over?

    After decades at the top of the investment food chain, hedge funds may be in decline.
  4. Managing Wealth

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  5. Investing

    How To Start a Hedge Fund In the United States

    A general overview of how to start a hedge fund firm in the United States, including complying with state and federal regulations.
  6. Investing

    3 Things Divorcees With Hedge Fund Investments Should Know

    Hedge funds are assets that can be very difficult to divide during a divorce.
  7. Investing

    Hedge Funds Tutorial

    Hedge funds can be an integral part of a well-diversified portfolio - if you know how to choose them.
  8. Investing

    Hedging With ETFs: A Cost-Effective Alternative

    Learn how the benefits of ETFs for hedging are numerous and can be enjoyed by investors of all sizes.
  9. Investing

    Why Hedge Fund Managers Make Good Advisory Clients

    Super-busy hedge fund managers should be viewed as an opportunity for sophisticated financial advisors who can step in and offer their services.
RELATED FAQS
  1. Are there publicly traded hedge funds?

    See why a privately arranged hedge fund may decide to take its fund public, and how the investing public at large can gain ... Read Answer >>
  2. Why do companies enter into futures contracts?

    Learn how companies use futures contracts to hedge their exposure to price fluctuations as well as for speculation. Read Answer >>
Trading Center