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Definition: Natural Hedge
Typical hedges are transactions that act in a manner to oppose any movement in the underlying security. In case of a natural hedge, the risk is reduced because of an institution’s normal means of operation. A typical example can be for example if an oil producer from the middle east Asia, sets up a refinery in India. In this case, all the exchange rate movements are hedged since if exchange rate swings in one direction, the operations are expensive but the income is higher, and in the other direction the income is lower but operations are cheaper.
These hedges are typically less flexible compared to the financial hedges since financial hedges can be created whenever needed. The natural hedges are at a greatly operational level and to that end, the flexibility is quite low.
In fact, we can have a natural hedge example in case of financial assets such as bonds too. We know that bonds perform well when stocks fall and perform poorly when stocks rise. This makes the pair a natural hedge against each other. Even in case of stocks, the process of buying long and short positions in stocks that are highly correlated, leads to a natural hedge offsetting the movements in one with movements in the other.