Getting Back to Natural Hedges

As companies revisit their hedging programs, some treasury groups are looking to reduce financial risks without using sophisticated financial instruments. Savvy treasury leaders optimize their organization’s natural hedges by improving data accuracy, carefully coordinating the timing of various transactions, and collaborating with internal business partners.

A natural hedge mitigates a specific corporate exposure via either investments or operational actions whose performance negatively correlates to the risk. For instance, a sales contract denominated in a foreign currency could offset a purchasing agreement in that same currency; such a relationship between transactions is a common natural hedge, notes Erik Smolders, a Deloitte Risk & Financial Advisory managing director in treasury management.

Amol Dhargalkar, managing partner, chairman, and global head of corporates at Chatham Financial, notes that treasury groups often quantify the benefits of their hedging programs and then assess the extent to which “natural hedging can accomplish the same objective—netting currency exposures or issuing non-USD [U.S. dollar] debt, for example.”

Treasury groups also can work with sales teams to explore whether the company has flexibility in setting the currency in which a contract is priced. Or they can work with business operations to determine whether certain expenses can be sourced in a currency that offsets impending sales, notes Chatham Financial COO Amanda Breslin. “For balance sheet risks, companies will often evaluate hedging benefits of adjusting A/R [or] A/P maturities, or cash holdings or conversions in currencies driving remeasurement risk,” Breslin explains. “Capital structure decisions should also consider the FX [foreign exchange] footprint to create offsets where possible.”

The growing use of in-house banks creates additional opportunities for natural hedges involving different legal entities within the same global company. “An in-house bank that manages and hedges currency exposures on behalf of multiple entities within the same group of companies can be a very effective technique to reduce the need for external hedging by finding offsetting natural hedges within the books of its sister companies,” Smolders notes.

As an example, U.S. dollar receivables on the books of a European sales entity could, on a consolidated basis, be naturally hedged against the U.S. parent company, which has a similarly sized euro-denominated payable. “Both [entities] could execute an internal hedge with an in-house bank entity, and the in-house bank finds itself hedged because of these offsetting internal transactions,” Smolders explains. “Or the organization could decide that the two entities do not need to do anything and the overall exposure is adequately hedged because of these offsetting balances.”

Optimizing natural hedges starts with the understanding that the program must reflect each company’s unique structure, geography, risks, and operations. “There is not a one-size-fits-all approach,” says Atlas Risk Advisory CFO Scott Bilter. “It really starts with understanding your data and being able to drill down into each entity to determine where the exposure resides before deciding what you can do to offset that exposure naturally.”

Data accuracy, timing considerations, and up-front communication also help strengthen natural hedging activities. “An effective natural hedging program typically relies on strong communication between treasury personnel, business units, and key stakeholders,” Breslin emphasizes. “Access to reliable data is also important in identifying natural offsets and [in] seeking out opportunities to create them. … A holistic business perspective is key. The timing of a natural offset needs to be considered as well, as a mismatch will still leave exposure to rate movement.”

See also:

• October 2022 Special Report
• To Hedge or Not to Hedge?
• 3 Quick Fixes for Hedging Efficiencies
• Beautifying the Business Case for Hedging Programs

Eric Krell’s work has appeared previously in Treasury & Risk, as well as Consulting Magazine. He is based in Austin, Texas.