Volatility is a measure of the degree of variation in the price of a commodity or other asset over time. It is typically measured by the standard deviation of the asset's returns. A higher standard deviation indicates higher volatility.
Volatility is caused by a number of factors, including:
- Supply and demand: If supply or demand for a commodity changes unexpectedly, it can lead to sharp price movements.
- Geopolitical events: Geopolitical events, such as wars or revolutions, can disrupt the supply of commodities or lead to increased demand for certain commodities, such as oil.
- Economic conditions: Economic conditions, such as recessions or booms, can also affect commodity prices.
Volatility can have a number of negative consequences for businesses and consumers. For businesses, volatility can make it difficult to plan and budget. For consumers, volatility can lead to higher prices for goods and services.
However, volatility can also create opportunities for investors. For example, investors can buy commodities when they are cheap and sell them when they are expensive. Investors can also use derivatives to hedge against volatility.
Overall, volatility is a normal part of any market. However, it is important to be aware of the risks associated with volatility before investing in commodities or other volatile assets.
Here are some examples of volatility:
- The price of oil can fluctuate wildly in response to news about geopolitical events or changes in supply and demand.
- The price of agricultural commodities can be volatile due to weather conditions and changes in global demand.
- The price of stocks and bonds can also be volatile, especially during times of economic uncertainty.
Investors can manage volatility by diversifying their portfolios and using hedging strategies.
How Business Hedge Against Price Volatility
Businesses handle price volatility in a number of ways, including:
- Hedging: Hedging is a strategy that businesses use to reduce their exposure to price volatility. Businesses can hedge by using derivatives, such as futures contracts and options contracts.
- Long-term contracts: Businesses can also lock in prices by signing long-term contracts with their suppliers and customers.
- Inventory management: Businesses can also manage price volatility by carefully managing their inventory levels. For example, a business that sells a seasonal product may choose to stockpile inventory during the off-season to avoid paying higher prices during the peak season.
- Pricing strategies: Businesses can also use pricing strategies to manage price volatility. For example, a business may choose to price its products above cost to create a buffer against price increases.
Here are some specific examples of instruments that businesses use to hedge against price volatility:
- Futures contracts: Futures contracts are agreements to buy or sell a commodity at a specified price on a specified date. Businesses can use futures contracts to lock in a price for a commodity in the future.
- Options contracts: Options contracts give the buyer the right, but not the obligation, to buy or sell a commodity at a specified price on or before a specified date. Businesses can use options contracts to protect themselves against price increases or decreases.
- Swaps: Swaps are agreements to exchange two different cash flows. Businesses can use swaps to hedge against interest rate risk, currency risk, and commodity price risk.
The best way for a business to handle price volatility will depend on the specific industry and the type of commodities that the business uses.