What is a Natural Hedge?

A natural hedge is a management strategy that seeks to mitigate risk by investing in assets whose performance is negatively correlated. It can also be implemented when institutions exploit their normal operating procedures, for example if they incur expenses in the same currency that their revenues are generated thereby reducing exchange rate risk.

Understanding Natural Hedges

A natural hedge entails using asset classes, that have historically exhibited contrasting performance in a given economic climate, to reduce a portfolio's or company's overall risk. The key concept is that by allocating resources to two different asset classes, the risk emanating from one asset should be offset by the return from the other and vice versa. Essentially, the cash flow from one should cancel out the cash flow from the other, thus fulfilling the concept of a hedge.

A company with significant sales in one country is exposed to currency risk when they want to repatriate that revenue. They can reduce this risk if they can shift operations to where they can incur expenses also in that foreign currency, which would qualify as a natural hedge. A commonly used example is that of 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.

Unlike other conventional hedging methods, a natural hedge does not require the use of sophisticated financial products such as forwards or derivatives. That said, companies can still use financial instruments such as futures, to supplement their natural hedges. For example, a commodity company could shift as much of their operations to the country where they plan to sell their product, which is a natural hedge against currency risk, then use futures contracts to lock in the price to sell (revenue) that product at a later date.

Most hedges (natural or otherwise) are imperfect, and usually do not eliminate risk completely, but, they are still deployed and are considered to be successful if they can reduce a vast portion of potential risk.

Key Takeaways

  • A natural hedge is a management strategy that seeks to mitigate risk by investing in assets whose performance is negatively correlated.
  • A company that generates revenue in another country's currency can implement a natural hedge against currency risk if they can also incur expenses in that same currency.
  • Unlike other conventional hedging methods, a natural hedge does not require the use of sophisticated financial products such as forwards or derivatives.

Other Examples Natural 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 mutual fund managers, treasury bonds and treasury 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. This is a relationship that has been historically valid most of the time, but not always. In the years after the 2008 financial crisis, this negative correlation between bonds and stocks decoupled as both moved in tandem (strong bull markets), so this natural hedge would not have been successful.

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.