Natural Hedge: a Worked Example

The Reserve Bank of Australia's survey of hedging describes these offsets as positions or cash flows in the same foreign currency cancelling an exposure, and notes that some Australian mining companies borrow in US dollars so their repayments line up with their dollar sales. That is the plainest form. Three others are common on a commercial file.

Costs in the currency of the sales: imported raw materials, freight, overseas staff. Pricing and sourcing decisions that create the same match, such as buying from a supplier that invoices in the customer's currency. And an overseas asset funded by debt in that country's currency, which offsets a balance-sheet exposure rather than a cash one and is a different thing again, as translation exposure explains.

None of these needs a forward contract or a derivative line, and none carries a dealing cost of its own, though a foreign-currency loan still has its interest and fees and a change of supplier may have a price. Each is less flexible than a contract, because it can be changed only by changing the business.

Four tests decide how much of the offset a lender will count. It must be the same currency, because a correlated currency is a bet on the correlation. The timing must be close enough, because a receipt in February does not meet a payment in November without a balance held across the gap. The amounts must be predictable, since a cost that can be switched to a local supplier next year is an offset only until then. And the offset has to survive the downturn: if sales fall, do the costs fall with them, and does the debt service?

That last test is where a natural hedge differs most from a contract. A forward states an amount, and a loan repayment states an amount, but a sale does not.

A maker of aircraft seat components, constructed for this page like every figure in it, sells US$10.0m a year in US dollars. It pays US$3.5m in dollars for aluminium and freight, and services a US dollar term loan with US$0.4m of interest and US$1.6m of principal a year. It has sold US$3.0m forward. The budget rate is 1.50 units of home currency per dollar. Suppose the dollar falls to 1.35.

About two-thirds of the protection here needed no hedging contract, and came from how the business and its loan were set up. Now take a poor year, in which sales fall 30% to US$7.0m. The dollar costs vary with sales at 35%. The debt service does not vary. Nor do the forwards.

The costs fell with the sales. The debt service and the forwards did not, so forwards sized on a better year have turned into over-hedging. A natural hedge is measured on a forecast, and it moves when the forecast does.

A forward or option is a contract: it has a stated amount, a date, and a bank's credit behind it. It needs a credit line, it costs something, and it can be put on for exactly the amount wanted and closed when no longer needed. A natural hedge needs none of that and offers none of that. Many exporters use both: the natural hedge first and contracts on what remains, which is how a desk reads the net position.

The accounts can tell a different story from the economics. If the company above owes US$8.0m and the dollar falls from 1.50 to 1.35, the loan reduces from 12.0m to 10.8m in home currency, and that 1.2m gain goes through profit or loss unless the loan is designated in a hedge relationship: the rule under IAS 21-based standards and FRS 102 alike. If the dollar rises, the reported loss arrives before the higher income it is hedging. A leverage covenant can also be pulled about, since the debt is translated at the closing rate and earnings at an average rate. Some agreements deal with this in their definitions.

DEFINED IN ONE PARAGRAPH → · TRANSACTION EXPOSURE → · HEDGE COVER →

A lender that finds a natural hedge has less to worry about and a different thing to check. The credit paper records the net position and how it was reached, and a forward line is sized to the net rather than the gross figure. The offset can also be built into the structure: a multi-currency facility lets an exporter borrow in the currency its debtors pay in, so that the receivables repay the loan without any conversion. Issue 02 is a file built around a facility of that kind.

The reverse case needs equal attention. A business with no income in a currency that borrows in that currency has created an exposure, however attractive the interest rate looked. And a loan that matches today's sales may not match next year's, so a lender asks what happens if the customer base moves to another currency, or a supplier is replaced with one that invoices at home. When the match breaks, the exposure comes back all at once.

FX FACILITIES → · HEDGING POLICY → · ISSUE 02 · THE EXPORTER →