A natural hedge is a risk management technique that seeks to mitigate economic risk exposure by matching cash flows. Essentially, it involves offsetting a position or exposure in one area with an opposite position in another area without the use of complex financial instruments such as derivatives.
Example of Natural Hedge
Consider a U.S.-based airline company, let’s call it AirUSA. The company’s major expense is jet fuel, which is priced and traded in global markets in U.S. dollars. Meanwhile, a large portion of AirUSA’s revenue comes from international routes and is therefore received in various foreign currencies. This creates a risk for AirUSA due to currency fluctuations. If the U.S. dollar strengthens against these foreign currencies, the revenue in U.S. dollar terms decreases.
However, if global oil prices rise, the cost of jet fuel, priced in U.S. dollars, will also rise. This increase in expenses can potentially be offset by the stronger U.S. dollar, which makes its international revenue worth more in U.S. dollars.
Remember, a natural hedge might not eliminate the risk entirely and it’s often not as precise as financial hedges. However, it is a cost-effective way for businesses to reduce their risk exposure without resorting to complex financial instruments.