When a company engages in transactions that involve another currency, it incurs a transaction risk that currency fluctuations will adversely impact its cash flows. They frequently purchase derivatives to hedge against these transaction risks. However, some organizations are reluctant to follow this path, because (1) derivatives can be expensive, and (2) FAS Statement 133 requires a company to charge fluctuations in the value of a derivative to the current reporting period if it cannot prove that the derivative effectively hedges an exposure. The later issue also requires a considerable amount of documentation work.
To avoid the use of derivatives, some companies have centralized their treasury operations, which gives the treasurer sufficient information about company-wide transaction flows to determine where transactions can offset each other. This information allows treasurers to create natural hedges, which require no FAS 133 documentation and are free. When using natural hedges, there will still be some residual exposure if revenues and costs do not exactly offset each other, but the remaining exposure is greatly reduced.
This technique is only possible if treasury operations are centralized, or if the information needed to construct natural hedges can be obtained by other means, such as through a data warehouse that accumulates information from multiple sources.
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A reader asks, “where can I find more information on natural hedging and the residual risk that still resides with natural hedging?”
There is surprisingly little information about natural hedges in any of the finance textbooks, though you can gain a general understanding of most other types of hedges in The Business of Hedging (by John Stephens) or Hedging Instruments and Risk Management (by Patrick Cusatis and Martin Thomas).
A good source of current finance-related information on the Internet is the Wilmott forums. To get there, enter www.wilmott.com in your browser, click on the “forums” option on the left panel, and select “The Quantitative Finance FAQs Project.”