Natural Hedges is the risk reduction that can arise from normal operating procedures of an institution. A company having sales in a country holds a natural hedge on the currency risk of the country if that country is also generating expenses for the company. The typical financial hedge act in a manner which opposes the movement of underlying securities of a transaction. In the case of natural hedges, the risk is naturally reduced with the means of operations of an institution.
The natural hedges are less flexible and work according to the exchange rate movements. If the exchange rate swings to one side, the operations will be expensive but will also offer higher income. In the other case, the operations will be more affordable, but the income will also go down. Natural hedges can be beneficial during improved operational levels.
Natural hedges are also applicable in case of financial assets such as bonds. When the stocks rise, the bonds perform poorly, but when the stocks fall, the bonds become better. It makes the pair a natural hedge against each other. The process of buying long and short positions in stocks are also correlated and develops a natural hedge.
So far, we have discovered that Natural Hedges are not flexible and offers a consistent benefit or loss according to the operations. It cannot be controlled by investors and can only be used during beneficial times. Let us now look at how natural hedging affects the financial market.
Natural hedging in finances
The portfolio managers look for hedging the downside risk, which also includes natural hedging. The assets that have been performing opposite each other constantly suit natural hedging. The portfolio managers need to specifically look for the historical trends of an institute while selecting a natural hedge. For example, when the equity grows higher, the bonds are shorted in order to cover the downside risk. Bonds can also go higher sometimes, which will tell that the equity has been performing poorly. Another way for natural hedging is to choose pairs trading. A portfolio manager picks up two stocks that are correlated, and if one stock performs well, it will offset the other stock.
Benefits of natural hedging
Natural hedging can provide consistent benefits while reducing the risk of investing on a single side of an institute. It helps in minimizing the risks and helps in the management of investments to avoid the downside. It will assure profits one way or the other and helps a company to survive the challenging market conditions. The investors and traders can also protect themselves from the volatility of price, inflation, and interest rate changes. Natural hedge provides a consistent profit without the need for constantly monitoring the market for adjustments.
Downsides of natural hedging
Hedging limits the profits to a certain extent and can even reduce the profits even further. As there is a low risk of downfalls, the rewards are also not higher. Natural hedging only offers low rewards. The portfolio managers need to constantly do hedging in order to efficiently control their portfolio.
Overall, natural hedging boosts the valuation, increases the ability to raise capital, and provides tax benefits. It is a great way of entering a new market and starts earning profits until you can create your own hedging and investment plans.
Natural Hedge and Financial Hedge
The main difference between natural hedging and financial hedging is that natural hedging is less flexible. But natural hedging does not need operational changes as it happens naturally according to the operations of the market. It also makes natural hedging easy to work with as it does not need complex financial products like derivatives or forwards. Even though both the hedgings are two different strategies, a company can use both in order to acquire maximum benefit. A company which deals in a commodity can shift their operations to a new country where they can sell their products to natural hedge against the currency risk. Later they can use contracts to hedge their risks even further.