Natural hedge
Capital MarketsMatching the currency of costs, or of borrowings, to the currency of revenue so an exchange rate move offsets itself without a derivative.
Also written: natural hedging, operational hedge
A natural hedge is protection built into how the business is arranged rather than bought from a bank. A company that sells in sterling and manufactures in the UK has one already: if sterling falls, both sides of its margin fall together and the percentage survives. A company that sells in sterling and manufactures in the euro area does not, and its margin moves with the exchange rate.
The same logic extends to the balance sheet. A euro group that borrows in sterling to fund a UK subsidiary has matched the currency of the debt to the currency of the cash flow servicing it. Under IFRS that borrowing can be designated as a hedge of the net investment in the foreign operation, so the currency movement on the debt goes to other comprehensive income alongside the translation reserve rather than through profit.
Treasurers prefer natural hedges where they can get them, and for practical reasons rather than elegance. There is no counterparty, no premium, no mark to market swinging through the accounts, and none of the documentation that hedge accounting demands. A derivative is what you use for the exposure you could not arrange away.
The limits are real. A pure exporter with a domestic cost base cannot manufacture a natural hedge without moving production, which is a strategic decision made over years rather than a treasury one. And a natural hedge only works to the extent the match is genuine: matching a euro cost against sterling revenue that turns out to be seasonal or contractually repriced leaves exposure the hedge report will not show.
Worked example
Illustrative. A euro reporting group buys a UK business generating £50 of operating profit a year and funds it with £200 of sterling debt rather than euro debt.
If sterling weakens, the euro value of the £50 falls, and so does the euro value of the £200 liability. The two move together, and the group's euro net asset position is far less exposed than if it had borrowed in euro.
The interest is also paid in the currency the subsidiary earns, so no conversion is needed to service the debt, which is the part treasurers care about most.