What is a Natural Hedge?

What is a Natural Hedge?

A natural hedge is a management strategy that seeks to mitigate risk by investing in assets whose performances are inherently negatively correlated. For instance, a natural hedge against owning financial stocks is to hold bonds, since interest rate changes tend to influence each in opposite fashion,

A natural hedge 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 they will actually reduce their exchange rate risk exposure, naturally.

A natural hedge is a strategy that seeks to mitigate risk by investing in assets whose performance is negatively correlated through some intrinsic or natural mechanism.

Natural hedges can also occur within a corporation, where losses in one part of the business operations are offset by others, and vice-versa.

Natural Hedge in Business Operations

The key to natural hedges is to allocate resources to negatively correlated assets that perform oppositely in an economic climate. The gain from one asset (or operational behavior) should be able to roughly offset the loss from another so that the portfolio or company’s risk is naturally hedged.

Companies that sell their products in foreign markets typically face currency risks. The risk can be hedged by incurring expenses in the same currency. Such a natural hedge strategy is less costly and much easier to implement than hedging with derivatives or forwards.

However, hedging by adjusting operational procedures is less flexible and less effective, as the value and timing of incomes and expenses might be very different.

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Another natural hedge method for currency risk is to borrow in the same foreign currency. For example, a U.S. company sells its products in Japan and collects its revenue in JPY. It will face a foreign exchange loss if JPY devalues relative to USD. To hedge the risk, the company can borrow money around the amount of estimated revenue in JPY.

If JPY appreciates in the future, the company will generate a foreign exchange gain by receiving revenues in JPY but a loss by repaying its JPY-denominated debt. If JPY depreciates, the company will experience a loss from its sales in Japan and a gain by repaying in cheaper JPY.

In both scenarios, the gain and loss can approximately offset so that the company holds a natural hedge against its currency risk.

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.

Natural Hedge in Portfolio Management

To hold a natural hedge for the downside risk of a portfolio, a portfolio manager can balance the holding of assets with negative correlations. The negatively correlated assets generate opposite performances most of the time. A portfolio manager needs to analyze the historical performances of assets to look for the ones with negative correlations.

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In general, the bond and equity market perform oppositely. A portfolio can be naturally hedged by holding both bonds and stocks in appropriate amounts. When the stock market tumbles, the loss from stocks can be partially offset by the gain from bonds, and vice versa.

However, even two negatively correlated assets may lose simultaneously in extreme cases. In the 2008 Global Financial Crisis, both the stock and debt market were badly hurt.

Pairs trading, as a market-neutral arbitrage strategy, can also be used to create natural hedges for portfolios. In the pairs trading method, a portfolio holds long and short positions in two highly correlated assets. As the values of the assets move in the same direction, the opposite positions create gains and losses that can offset each other.

Asset allocation is essential to natural hedges in portfolios. A portfolio manager needs to carefully determine the ratio of the assets to hold by analyzing their correlations. Also, assets with positive (negative) correlations do not always move in the same (opposite) directions. The hedge is not always effective.

Examples of 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 prices 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.

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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 (e.g., 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.