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October 2023

Natural Hedging – A Practical Approach to Designation and Effectiveness

By Sanjay Chauhan, Chartered Accountant
Reading Time 16 mins
A. Introduction
 
Predictability of cash flows is one of the primary goals of a business while charting its short-term as well as long-term capital management plan. For this, risk management is one of the important aspects. The company is exposed to various risks ranging from political, geographical, economical to natural risks. One of the risks that we are going to discuss is exposure to foreign exchange fluctuation risk and hedging through a non-derivative instrument. Foreign currency exposure in a business originates on various transactions such as import and export of goods/services, foreign currency borrowings, overseas investments, etc. A company can manage this risk with a clear risk management and treasury policy. If the company opts to hedge its foreign exchange risk, it can do it by passive hedging or active hedging.
 
B. Hedging
 
In simple terms, from a foreign currency risk perspective, it is a technique or an approach whereby an entity can secure or ring-fence its cash flows while the exchange rate may fluctuate in future till the expected foreign currency cash flows hit the bank account.
 

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