A natural hedge is an intuitive strategy that aims to reduce risk by investing in assets whose performances are inherently negatively correlated. For instance, holding both financial stocks and bonds can form a natural hedge because interest rate changes typically impact these two in opposite ways.
A natural hedge can also manifest when institutions align their operational procedures. For example, if a company incurs expenses in the same currency as its revenues, it naturally mitigates its exchange rate risk.
Key Takeaways
- A natural hedge is a strategy that seeks to mitigate risk by investing in assets with naturally negative correlations.
- Natural hedges can occur within a corporation where one operation’s losses offset the gains in another, and vice versa.
- Unlike conventional methods, a natural hedge doesn’t require complex financial products like derivatives.
Exploring the Intricacies of Natural Hedges
A natural hedge involves leveraging asset classes that historically show contrasting performance in specific economic climates to reduce a portfolio’s or company’s overall risk. By spreading resources across two different asset classes, the risk associated with one is counterbalanced by the returns from the other.
For example, a company that generates significant sales in a foreign country faces currency risk when repatriating revenue. They can mitigate this risk by incurring expenses in that foreign currency, qualifying as a natural hedge.
Real-World Example
Consider an oil producer located in the US that partially hedges against crude oil costs since crude prices are denominated in U.S. dollars. While the company can adapt its operations to exploit a natural hedge, these hedges are generally less flexible than financial hedges.
Points to Ponder
Natural hedges sidestep the need for sophisticated financial tools like forwards or derivatives. Nevertheless, companies sometimes use financial instruments such as futures to bolster their natural hedges.
Example
A commodity company may shift their operations to a country where they plan to sell products—this acts as a natural hedge against currency risk. They may then use futures contracts to fix the selling price for the product at a later date.
Most hedges, whether natural or otherwise, are imperfect but nonetheless useful in reducing significant portions of potential risk.
More Examples of Natural Hedges
Natural hedges often appear in business structures that guard against exchange rate volatility. For instance, a business operating with suppliers, production, and customers in the same currency can source raw materials and components in the consumer’s country and set costs and prices in the same currency.
For Mutual Funds
Mutual fund managers often use treasury bonds and notes to naturally hedge against stock price volatility. While bonds tend to perform well when stocks falter (and vice versa), this correlation is not infallible. Following the 2008 financial crisis, bonds and stocks moved in tandem, making this natural hedge less effective during that period.
Pairs Trading
Pairs trading is another form of natural hedge, where the investor takes long and short positions in highly correlated stocks to balance each other’s performance.
Related Terms: Hedge, Correlation, Expenses, Revenues, Exchange Rate, Forwards, Derivatives, Futures, Derivatives.
