What it means
Most financial risks can be reduced by taking an opposite position. A company that will receive foreign currency can sell that currency forward, and an investor who owns a share can buy a put option.
A naked position is what is left when no such protection exists. The word is most often used in trading.
A trader who writes an option without owning the underlying asset has a naked position, as does a trader who sells a security short without having arranged to borrow it. In both cases a market move against the trader produces a loss with nothing to absorb it.
The term also applies in corporate finance. A business that sells in foreign currencies but does not hedge has a naked currency exposure, and a manufacturer that does not lock in the price of a key metal has a naked commodity exposure.
These exposures can swing profit up or down without any change in the underlying business. Being naked is not always a mistake.
Some firms deliberately leave a portion of exposure open, either because hedging is costly or because they want to benefit from favourable moves. The danger is leaving positions naked by accident, or leaving them at a size the business cannot afford to lose.
A good control is to measure the unhedged amount regularly and compare it to a board-approved limit. Reporting it as a percentage of total exposure makes it easy for non-specialists to see.
It is also worth remembering that a hedge has a cost and can fail. Forward contracts lock in a rate and remove the chance of gain, and options cost a premium, so a fully hedged business pays for certainty with either lost upside or cash.
In practice
Real-world examples.
Example
A furniture importer pays its overseas supplier in a foreign currency but does not buy forward contracts. Its profit margin on each shipment swings with the exchange rate, making it a naked currency exposure. A 5% move in the exchange rate on a $2,000,000 shipment changes its cost by $100,000, which is more than the profit on the order.
Example
A trader sells shares short without checking that any can be borrowed. When the shares cannot be found for delivery, the trade becomes a naked short and attracts regulatory attention.
Example
An airline hedges 70% of next year's fuel needs and leaves 30% open, because its finance director wants some benefit if oil prices fall. The unhedged 30% is a deliberate naked position, set within a board-approved limit. The finance team reports the figure to the board each quarter, together with the potential gain or loss from a 10% move in fuel prices.
Formula
Calculation
Naked exposure = Total exposure - Hedged exposure
Naked percentage = Naked exposure / Total exposure
A company expects to receive 2,000,000 units of a foreign currency over the next year and has sold forward contracts covering 1,500,000 units. The naked exposure is 2,000,000 - 1,500,000 = 500,000 units, which is 500,000 / 2,000,000 = 25% of the total.
If each unit is worth $0.50, the naked exposure is 500,000 x $0.50 = $250,000. A 10% adverse move in the exchange rate would cost $250,000 x 0.10 = $25,000, and the same move in the company's favour would add the same amount.Case study
Seen in the real world.
Tidewater Foods is an illustrative, fictional exporter of packaged snacks, selling mainly in one foreign currency. Management had never hedged, reasoning that gains and losses would even out over time.
When the currency fell 15% against the dollar over six months, the company's reported margin dropped from 18% to 11% even though sales volumes were unchanged. The finance director calculated that $4,000,000 of annual foreign revenue was completely naked.
In this illustrative story the board adopted a policy to hedge at least 60% of expected receipts a year ahead. The remaining 40% stayed open on purpose, with a monthly report showing the size of that exposure.
Watch out
Common mistakes.
- Assuming that a natural offset exists when it does not, for example believing foreign costs will cancel foreign revenue when they are in different currencies.
- Treating a naked position as always bad, when some firms choose to leave part of an exposure open.
- Failing to measure the exposure, so nobody knows how large the unhedged amount really is.
Questions
People also ask.
Is a naked position illegal?
No, not in general, but certain types such as naked short selling are restricted or banned in many markets.
How do you remove a naked position?
By taking an offsetting position, such as a forward contract, an option or a matching asset. The cost and timing of the hedge should be weighed against the size of the risk.
Does a naked position always lose money?
No, it can gain as easily as lose, but the outcome is uncertain and unprotected. Finance teams usually prefer to choose their risks deliberately rather than leave them open by default.
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