The financial derivatives industry started life as a way for businesses to hedge commodity, currency and other price risks, by allowing a farmer, for example, to sell his crop in advance for a fixed price (a forward contract). Insurance contracts are another way to hedge against the risk of accidents, natural disasters, loss of key people, etc.

A natural hedge arises when a business invests in two different assets or business units where the cash flows from each cancel out some particular risk. When things go bad for one, they go well for the other, and vice versa. If a man with an ice cream business invests in an umbrella business, he has a natural hedge against the weather and makes money whether it rains or shines. (This example falls down slightly—when it really shines, he makes money twice over by selling ice cream and sunshades!)

It’s worth looking for natural hedges and exploiting them to create value. One electronics client had an established business unit making cathode ray tube (CRT) monitors for computers and a new unit in the then-emerging market for flat screen monitors. Both units were very concerned about how rapidly their customers would make the switch over the next few years from the old technology to the new. Looking at each business unit individually, this was the dominant uncertainty that determined their NPVs. Both business units were doing what they could to swing the variable in their favour, thus spending resources competing vigorously with each other.

Looked at from the parent company, of course, this makes no sense. This particular uncertainty has no impact on the combined NPV—a slow take-up of new technology is good for CRTs and bad for flat panels, and the opposite is true for a fast take-up. The two businesses together are a great natural hedge. By combining the two business units, or at least getting them to co-operate, resources spent fighting each other are saved and can be reinvested to persuade customers to transition from CRTs to flat screens at whatever speed they like, as long as they don’t switch brands.

See also: Value based management in electronics.