Natural Hedge

What is Natural Hedge?

Natural hedge meaning refers to the process of Investing in assets that have a negative correlation. This helps investors mitigate financial risks. If the value of one currency drops, the other currency will help investor recover their losses. In other words, the negative trend in one currency will be counterbalanced by the positive trend in another currency.

It is easier for beginners to practice natural hedging as it is a simple and cost-effective process. It doesn’t involve any complex Technical Analysis or financial products. In fact, it is seen as the risk diversification process that encourages people to invest in different investment instruments to mitigate the risks.

Breaking Down the Natural Hedge Strategy

For example, a currency trader that has invested in Euros can mitigate their currency risks by investing in US dollars. If the value of the Euros depreciates, their loss will be compensated by the appreciation of the US dollars. In other words, a natural hedge is an investment strategy that focuses on the asset classes that share a negative correlation. It encourages the investor or a company to invest in assets that have a history of contrasting performances. This is especially done to control the risks.

The goal of this strategy is to get the best returns by diversifying the investment Portfolio. For example, an investor can buy shares from two companies that have negative correlations. If one company underperforms, the risk of the investor will be Offset by the returns they earn from the progress of another company. While a natural hedging strategy can help mitigate your investment risk to a great extent, this technique isn’t flexible.

Does it Work?

One major benefit of natural hedging is that it isn’t associated with derivates and other complex financial instruments. Of course, that doesn’t mean the investors cannot allocate their resources to futures and options. You could choose derivates to supplement the natural hedging strategy. As mentioned before, natural hedging isn’t always a feasible solution. It does not eliminate investment risks completely. However, experts believe that natural hedging is one of the best ways to mitigate a major portion of the risk associated with your investments.

The most common use of natural hedging is in the currency exchange Industry. For instance, if the Manufacturing and workers are all in one country, then the brand could decide to get the Raw Materials and other manufacturing inputs in the currency of their final customers. Another example is the treasury Bonds and stock price. Both share a negative correlation, making stock price movements the hedge of bonds.

Basically, stocks perform well when the bonds are underperforming. The latter is seen as the safest asset while the stock price is often associated with aggressive assets. It is important to note that stock and bonds have a negative relationship, however, that might not always be the case. There is a chance both stock and bonds can go in tandem. If that happens, the natural hedging strategy will Fail.