Natural Hedge

A natural hedge is a way of reducing financial risk by arranging a business's own operations so that one exposure offsets another, rather than by buying a hedging instrument. In foreign exchange, it usually means matching receipts and payments in the same currency, so that a change in the exchange rate raises the value of one side while lowering the other. A firm that earns and spends the same currency has less need to convert, and less to lose if that currency moves.

Natural hedging is also called operational hedging. It sits alongside, and often reduces the need for, financial hedging with instruments such as forward contracts, options and FX swaps.

Currency risk arises when a company's cash flows, assets or liabilities are denominated in a currency other than the one in which it reports or pays its owners. A natural hedge creates an offsetting position within the business itself. Common techniques include:

• Matching receipts and payments. Paying suppliers, staff or rent in the same currency that customers pay in.
• Local sourcing or production. Moving part of the cost base into the countries where sales are made.
• Matching debt to assets. Borrowing in the currency of a foreign subsidiary's assets or revenues, so that a fall in the currency reduces both the asset and the debt.
• Invoicing choices. Agreeing contract currencies with customers and suppliers so that exposures cancel.
• Internal offsetting. Using netting between group companies and centralized treasury management to cancel opposite flows before anything is converted.

A US company sells goods to Chinese customers and receives 7 million renminbi a quarter. It also buys components from Chinese suppliers costing 5 million renminbi a quarter. Without a natural hedge, it would convert all 7 million into dollars and then buy back 5 million renminbi to pay suppliers, paying an FX spread or FX markup each time. This is an avoidable form of double currency conversion. By holding renminbi in a multi-currency account, often in offshore RMB, and paying suppliers directly from it, the company converts only the net 2 million. Its exposure to the currency pair falls by more than two-thirds, and its conversion costs fall in proportion.

Natural hedges cost little to maintain because they rely on existing business flows rather than paid instruments. They do not expire, as derivatives do, and they do not require credit lines with banks, margin or collateral. They can also protect against longer-term "economic" exposure, such as a sustained currency move that changes a firm's competitiveness, which short-dated financial hedges handle poorly.

A natural hedge is rarely perfect. Receipts and payments may differ in amount or timing; a customer may pay 60 days after a supplier must be paid, leaving a gap that has to be bridged. Changing supplier payment terms or invoicing currencies may not be commercially possible. Some currencies are subject to capital controls that limit how they can be held or moved offshore, which can make matching harder. Restructuring a supply chain to create a hedge can also introduce new operational, legal or concentration risks that outweigh the currency benefit.

For these reasons, treasury teams commonly use natural hedging to reduce the size of an exposure and then cover the remaining net amount with forwards or options. Under a floating exchange rate regime, where currencies can move substantially, the combination is generally more efficient than hedging every gross flow separately.

The idea applies to other risks. An airline that owns a refinery, a mining company whose costs and revenues both depend on the same commodity, or a bank whose assets and liabilities reprice at similar times all benefit from partial natural hedges. In each case, the goal is to make the business's own structure absorb part of the shock that would otherwise require a financial contract.