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The Allure and Pitfalls of Natural Hedging

As finance managers, directors and business owners tap-dance their way around the whims of the international currency market, the term 'natural hedging' serenades as a harmonious solution for currency management. It's appealing, it's suave, and it puts up a dazzling front of cost-savings—yet, as we slip behind the curtains, we unveil the unnoticed missteps that could cost the finale.

Understand Natural Hedging

Natural hedging is an intriguing dance with foreign exchange (FX). It's the art of planning your business's currency inflows and outflows—namely payables and receivables —to counterbalance each other within the same currency bracket. In an ideal situation, this would eliminate the need for currency conversion completely, leaving you immune to currency fluctuations.

Effective natural hedging involves two primary steps like a well-choreographed step dance routine. Step 1: Collect Your Receivables — This is akin to the initial beat of the dance, where you focus on collecting your receivables first to establish a positive balance in the foreign currency. Just as the first move sets the tone for the dance, receiving payments first provides a financial cushion, safeguarding against potential currency fluctuations. Step 2: Pay Your Suppliers — This is equivalent to the next move in the dance, where you pay your suppliers using the positive balance you've established. It's a strategic step, reducing the need for currency conversion and, in turn, minimizing your exposure to exchange rate risks. Repeat these steps in rhythm with your business operations, and you will have a well-executed natural hedging strategy, just like a flawless step dance routine.

The Appeal

The promise of natural hedging is a siren's call—reduce transactional costs, evade conversion fees, and sidestep the volatile tango of the Forex market. Who wouldn't be seduced by the prospect of skirting hefty hedging contracts or options, all while seemingly cutting down the currency risk?

Three missteps to avoid

1. Holding currency balances: Working Capital Lock-In

The first misstep in natural hedging is the lock-in of capital. It's a subtle yet critical aspect often overlooked in the initial glow of potential cost savings. Due to the inherent unpredictability of business operations, cash flows can rarely be perfectly matched. You might receive payment in a foreign currency today, but your corresponding expenses in the same currency might not be due until the next month or even later. This discrepancy requires you to hold onto the foreign currency balance, effectively locking in your working capital. This phenomenon can restrict your liquidity and limit your capacity to quickly respond to other financial needs or investment opportunities.

2. Asking suppliers to change invoicing currency: A Hidden Cost

The second misstep in natural hedging involves supplier invoicing. It may seem convenient to ask your foreign supplier to invoice in your local currency, eliminating the need for you to deal with currency exchange. However, this approach often comes with a hidden cost. While it's true that you won't have to worry about conversion rates and fees, your supplier will.

To cover their risk and any currency conversion fees they incur, suppliers often embed a 2-3% currency exchange fee, or mark-up, into their invoicing. This additional cost is subtly woven into your payable amount, effectively increasing your expenses without your express knowledge. So, while it might seem like you’re simplifying your accounting, you’re actually paying more in the long run.

3. Matching Uncertain Cashflows: The Unseen Risk

The third misstep in natural hedging is trying to match highly predictable cashflows with speculative cashflows. This approach seems tactical in theory, but it can backfire with serious repercussions. Let's consider a scenario: your business has a probable inflow in a foreign currency from a dependable client, and you plan an outflow in the same currency, contingent on a speculative deal yet to be finalized. If all goes according to plan, these cashflows offset each other, and you've successfully implemented a natural hedge.

However, should the speculative deal fall through, your business is left holding the foreign currency from the inflow, exposing you to the unpredictable swings of the currency market. Not only does this situation strain your company's financials, but it also undermines the primary objective of natural hedging—for protection against currency risk. Hence, while matching cashflows, it's critical to ascertain the certainty of both inflows and outflows to reduce potential exposure to currency risk.

Alternative Steps

One cannot ignore the allure of natural hedging, but it's worth considering raised eyebrows at the simplistic beauty of this method. As an alternative routine, small steps like low-cost prebooking guaranteed FX for specific foreign invoices can equip businesses with the agility to manoeuvre through the FX market's highs and lows, much like a planned adagio in a high-stakes ballet performance.

The Final Bow

Natural hedging requires a keen balancing act, a harmonious interplay of vigilance and strategic execution. Finance managers and small business owners need to be cognizant of the masquerade natural hedging can sometimes be—a carefully crafted artifice that might cost as much as (or more than) the currency risks it aims to mitigate.

The symphony of managing currency risk is nuanced, and while natural hedging may strike the right chords, it's beneficial only when conducted with precision. Therefore, I urge fellow maestros of finance to survey their orchestra thoroughly, ensuring each player—the cashflow, the supplier, the FX strategy—is perfectly tuned for the act.

In the discourse of any hedging, scepticism makes for a prudent partner. Keep your wits sharp, your steps calculated, and may your financial ballet be ever-graceful and bereft of the lurking pitfalls.

To learn more about different types of hedging, read more in our comprehensive guides: