Natural hedge definition
/What is a Natural Hedge?
A natural hedge is a risk mitigation technique that involves investing in asset pairings that are negatively correlated. Natural hedges also occur through the normal course of business; for example, a company that conducts operations in another country will have minimal currency risk, because cash inflows and outflows are in the same currency. This means that a firm might set up supply chains within the country in which it produces and sells goods, so that currency risk is largely avoided. Otherwise, if it only sold into that country but had operations elsewhere, then it would be exposed to currency risk when repatriating the cash back to corporate headquarters.
Natural hedges are designed to be relatively simple to operate, without much financial manipulation. Instead, the business is structured to minimize risks, reducing the need for derivatives and other exotic financial products. However, natural hedges rarely eliminate all of the risk, so some additional hedging is usually needed to minimize the total risk level to which a business is subjected. Nonetheless, the use of natural hedges can greatly reduce the cost of the derivatives that a business must purchase in order to cover its financial risks.
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How to Set Up a Natural Hedge
The essential approach to natural hedging is to find asset classes that react differently to an economic situation, so that changes in their cash flows offset each other. In short, if an economic event triggers an increase in cash flow from one asset class, then it should trigger negative cash flow in the other asset class, so that the two sets of cash flows cancel each other out.