Natural Hedging is the balancing act by adding assets that have a negative correlation. A company can also go for a natural hedge by using its normal operating procedures. For instance, incurring expenses in the same currency in which the company generates revenues. This lowers exchange rate risk.
For instance, an oil company may relocate its refining operations in the United States to naturally hedge against the cost of crude oil. The reason is that the cost of crude oil is denominated in U.S. dollars.
Another example of a natural hedge is that a company’s suppliers, production, and customers belong to the same country. This will allow the company to set costs and prices in the same currency. For example, Apple is producing and selling iPhone SE in India.
Natural Heading in Financial Market
A portfolio manager always looks for hedging the downside risk, and natural hedging is one of the options. Assets with a long history of performing opposite each other are a perfect fit for a natural hedge.
While selecting the natural hedge, portfolio managers must go by the historical trend. For instance, the natural hedge against the equities is a bond. In a portfolio where equities are long, one should short bonds to cover the downside risk.
Bonds are known to perform poorly when equities are performing well, and vice versa. Such a relationship between equities and bonds has been in existence for ages. However, during the 2008 financial crisis, both the assets were moving together.
Another way to natural hedge is to go for pairs trading. Under this, a portfolio manager goes for long and short positions in two stocks with a high correlation. The idea is the performance of one offsets the performance of the other.
Advantages of Natural Hedging
- Risk minimizing strategy that helps the management to avoid the downside.
- One of the ways to lock in profits.
- It helps the company to endure challenging market conditions.
- Protect traders against volatility of price, interest rate changes, inflation, and currency rate changes.
- It also saves time as the company would not have to adjust on the basis of daily volatility.
- Hedging has its own cost, and therefore, it can reduce the profit to that extent.
- Since low risk means low reward, so reducing risk will automatically convert into lower profit.
- Hedging has to be done actively to efficiently manage the portfolio.
Strategic Benefits of Hedging
Hedging helps in increasing the valuation of a company. It has been tested as well. According to research, hedging helps in increasing Tobin’s Q significantly.
Tobin’s Q= (Equity market Value + Liabilities market Value)/(Equity Book Value +Liabilities Book Value).
If the value of Tobin’s Q is above 1.0, it means the company’s market value reflects unrecorded assets. A company with a higher valuation has so many advantages, such as the ability to enhance sales, divest, and acquisition. Since hedging helps in increasing the valuation of the firm, it helps a company to fetch a better price in case it is the target of acquisition.
Increases Ability to Raise Capital
Hedging also helps a firm to increase its ability to raise capital for expansion and investment. A company draws fund from two major sources – Debt and Equity. The decision for investment is taken on the basis of the Sharpe Ratio. This ratio includes the expected value of the rate of return after the risk-free rate. This value is then divided by the standard deviation of the return.
Sharpe Ratio basically explains the extent to which the return covers the risk taken by an investor. With the help of hedging, a company can increase the Sharpe ratio for the level of earnings, and therefore, the deal starts looking more lucrative to the investors.
The firm stands a better chance to borrow when it applies hedging into the mix. The simple idea is that the company can easily pay the debt holders as its cash flow improves. This way, debt holders gain more confidence in the company and thus, would not hesitate when lending more money.
Hedging also helps companies with taxation as lower-income volatility would help them in reducing their tax liability. Another way in which hedging helps with taxation is an increase in debt capacity leading to a lower tax burden. Since we read above that hedging boosts a company’s ability to raise more debt. Therefore, more debt (and more interest) would lower earnings for the company, resulting in lower taxes.
New Market Entry
While expanding in different countries, companies face currency risk. Not to mention, there are countries with highly volatile currencies. Therefore, it becomes important for the company to hedge against such movements.
Natural Hedge vs. Financial Hedge
Natural hedging is less flexible than financial hedging, as, in the former, a company has to make operational changes. Another difference is that a natural hedge does not require complex financial products, such as derivatives or forwards.
Though both are different, a company can use the two together to get the maximum benefit. For instance, a company dealing in a commodity may shift their operations to another country where they plan to sell their product to a natural hedge against the currency risk. The same company can then use futures contracts to further hedge its risk.
A company should go for hedging only if it sees a considerable benefit in it. A firm should properly assess the impact of the commodity or the instrument that they are using as a hedge. If the commodity has very little effect on their bottom line, then there is no point in bearing the cost of hedging.
Moreover, there are occasions or risks for which the company doesn’t need to deploy the hedging tactic at all. Making certain operational changes or adopting new tactics might also help mitigate risks. The idea should be to use a hedge only when it matters.
Also, managers must understand that hedging does not offer complete protection against the risk. Rather it may lower the risk to some extent.