Natural Hedge

In finance (and gambling), a hedge is an attempt to reduce exposure to a risk by investing (or placing a bet) on something that pays out if the original risk goes sour. Financial derivatives are a way for businesses to hedge commodity, currency and other price risks. They allow a farmer, for example, to sell his crop in advance for a fixed price (a forward contract), thereby eliminating the risk of price fluctuation from weather and other uncertainties. Insurance contracts are another way to hedge against the risk of accidents, natural disasters, loss of key people, etc.

A natural hedge arises when a business invests in two different assets or business units where the cash flows from each cancel out some particular risk. When things go bad for one, they go well for the other, and vice versa. If a man with an ice cream business invests in an umbrella business, he has a natural hedge against the weather and makes money whether it rains or shines. (This trite example does fall down—when it is really sunny, he can make money twice over by selling ice cream and sunshades!)

It’s worth looking for natural hedges and exploiting them to create value. For a risk-averse investor, removing risk without changing the expected value of a business increases the certain equivalent value.

Real-World Examples

• Long-term foreign currency exposure can be hedged by investing in manufacturing and other facilities operating in the same currency zone as the sales revenue.
• Security of supply, eg, of power or some essential raw material, can be hedged by investing upstream in a power plant or production of the raw material.
• Enron (long before the lunatics took over the company) was founded on the principle of taking on, for a price, the risks of buyers and sellers at both ends of a pipeline. With gas-price risk perfectly hedged, Enron made money on the risk premium it charged at both ends.

And My Own Clients...

• An electronics giant benefited from the realisation that their cathode ray tube (CRT) and flat screen monitor business units cancelled out a critical uncertainty faced by both: the speed with which the market switched from old to new technology.

Do you have other examples worth adding to this list?