Managing Commodity Price Volatility - Essay Example

?Managing Commodity Price Volatility Managing Commodity Price Volatility Volatility refers to the measurement of prevailing changes, normally calculated as a standard deviation from the current figures. Price volatility refers the notable price changes in commodities observed over a specified duration. Commodity prices typically keep on changing uncontrollably; hence introducing the necessity to calculate the variances in prices. The standard deviation of these prices is generally referred to as the price volatility, presented either in currency form or as a percentage. The commonly utilised value for price volatility is the percentage, which serves to eliminate the problems presented by changing currency values, when presenting volatility of commodities available globally. In most circumstances of international commodity price volatility, economists normally utilise a common currency, like the dollar to represent volatility. International businesses, however, present the calculation of volatility in terms of percentage of a specified figure. Volatility normally revolves around measurement of dispersion observed in numerous securities or market index. The calculation of volatility enables economists to predict the amount of uncertainty existing for given commodities. The uncertainties are normally presented by notable changes observed in the commodity prices. These changes are utilised in making predictions concerning stability of stocks and expected changes, based on previous observations. Volatility represents commodity risk and high volatility indicates high investment risk in such stocks. The risk is normally presented by anticipated change, with stocks having high volatility being marked as expected to have dramatic price adjustments over a short duration. Price fluctuations remain a fundamental constituent of calculated volatility values established by economist. Stable commodities customarily experience minimal fluctuations; hence lower volatility for such commodities. Stability in commodity prices does not occur often within the free market economies as demand and supply change continuously. Expanding boundaries of national economies dissolving into the global economy have contributed to increased difficulty in management of commodity price volatility. Technological advancements have contributed significantly towards a global shift in the living standards, consequently resulting in increased price volatility. Within the global economy, price control continues to become increasingly difficult because of the existing policy discrepancies among different countries. The concept of free market has continued to create an unprecedented, uncontrolled flux in pricing within the global market. Increases in commodity demand against the available supply continue to have a negative impact on the prices, causing increased price volatility. Investors, within the business world, commonly rely on volatility when making numerous investment decisions. Through volatility the individuals can make estimations of expected returns on investments, based on security volatility. Management of volatility remains a fundamental element for investors seeking success in the constantly changing commodity prices in the free market. Though volatility could be utilised in making future predictions, numerous changes could be initiated in the management process of volatility, consequently avoiding the adverse effects created by high volatility. The business decisions made following estimations from volatility consist of numerous assumptions. One major assumption in estimating volatility remains the unchanging business environment, enabling constant business conditions. Though calculations remain accurate, as they are based on current market prices, the prevailing business conditions resulting to the result cannot remain fixed. Governments, for example, might introduce regulations and policies seeking to protect investors from adverse effects of volatility. Changes in the business environment might create different business conditions, resulting in price stabilisation, for previously unstable stocks; consequently reducing volatility in future. Price volatility could have adverse effects on a company’s profitability if changes occur on the increasing side. Many businesses suffer the consequences of volatility for failure to prepare and introduce proper management methods, aimed at ensuring profitability during price volatility periods. Evaluation of the imminent risk as presented by commodity volatility remains an essential feature utilised when initiating volatility management.1 Once the risk becomes sufficiently estimated, the prediction of the expected changes can be made accurately. This risk evaluation generally occurs through observation of the trend and change in prices whether increasing or decreasing. This change remains important as volatility only appears as a positive figure, regardless of the direction of flux in price. Businesses should therefore, seek to establish the direction of change before making financial decisions based on volatility figure. Generally, commodity price changes occur at different stages of product development, presenting different business risks based on the direction of change. Changes can occur at three different stages; commodity production, commodity conversion or the commodity consumption. The management of volatility normally depends on the stage at which the price volatility occurs. At the commodity production stage price changes include the change occurring upon raw materials utilised in the production of various commodities. Changes occurring at the production stages normally affect the entire commodity movement chain up to the consumer. Constantly fluctuating prices of oil, for example, create a similar price fluctuation on many commodities utilising oil during manufacturing. At times, manufacturers or commodity converters cannot increase the price of commodities based on price volatility for raw materials. When making future profit planning, the element of volatility becomes fundamental towards providing sufficient estimations. Following evaluation of imminent risk presented by volatility, businesses would be advised to purchase commodities which can be utilised for a specified duration. The business normally estimates a range of price under which the business could operate profitably. Generally the approach takes two directions of optimism and pessimism. A graphical representation of the expected price fluctuation can normally offer sufficient information regarding price volatility. A business should know the positive or negative range where it would operate profitably, under current selling price. The business can then purchase materials at the current price, which would be utilised for the estimated duration which the company expects to operate profitably. Making predictive purchasing for raw materials becomes important and eliminates the possibility of making losses when raw material prices increase. The material purchased, however, should be limited to a specified duration, estimated from observed raw material price volatility.2 If the raw material prices reduce, competitors who had not purchased earlier could have a competitive advantage. Elimination of this occurrence, therefore, becomes a fundamental element when making estimations. Businesses would purchase materials for utilisation up to a limited time, under which they remain profitable despite the changing raw material prices. Such purchases ensure price stability at the consumption stage of the commodity production chain. Following such decisions, businesses protect their clients from constant price changes, through creating stability in the selling price. This method of estimation works in ensuring continuity of estimated business profits. Should raw material prices fall, the business could purchase more raw materials and mix with the previously purchased materials and enhance profitability. When seeking to increase profits under highly volatile commodity prices, businesses would generally take a market based approach. The business would analyse prices based on volatility occurring at the consumption stage. This would normally include analysing the prices of commodities based on the market situation. The business would create sufficient knowledge of the market; consequently monitoring the market for positive elements. This knowledge would become essential in enabling the business to gain a competitive advantage. The business would be able to estimate the prices which they could sell and maintain profitability, based on commodity demands on the free market economy. Within the situation of seeking profit increase, businesses need to have sufficient knowledge of impending market changes. This occurs in regard to policies, which might be introduced, and expected consumer commodity demand. While utilising the market based approach, businesses should normally collaborate with the different business stakeholders, seeking to gain sufficient market-related information. This would minimise the assumptions associated with price volatility estimations and provide a more realistic market evaluation process.3 This would include conducting market research targeting business customers and partners as respondents. These stakeholders present businesses with essential market-related information which can be utilised in making sound, informed decisions regarding product pricing. Through sufficient market knowledge, businesses can implement methods aimed at increasing profitability, through minimising the existing risk. Market analysis and evaluation enables businesses to have a realistic understanding based on actual market figure, consequently reducing the assumptions associated with price volatility as an estimation method. Conducting market research remains essential in minimising the number of estimations included in the calculation of volatility, when making business investment decisions. Leveraging can also be sufficiently employed by businesses in managing commodity price volatility. Leveraging can enable businesses to acquire capital for making investments into business options presenting minimal risks.4 Following evaluation of the imminent price volatility, businesses might require to increase the stock available within the warehouses, and efficiently ensure stability. Increasing the purchases might become difficult when companies operate within limited financial budgets. Borrowing becomes the only possible source of finances to ensure businesses reach their desired targets. While some investment options might be viable in reducing price volatility effects, ensuring sufficient financing for these investments could be difficult. Leveraging, however, should be utilised in making investments following sufficient evaluation indicating sustainability and profitability of the desired investment. This would ensure the company completely repays the borrowed finances. In the management of commodity price volatility, businesses should consider diversification as a method of protecting themselves from the effects of price volatility. This includes making investments in options presenting minimal business risks, and showing prospects of being highly profitable. A baking business, for example, specialising in cake could see the price changing continuously, affecting business profitability. Such business could begin offering other bakery products with lower price volatility as a method of maintaining overall business profitability.5 The diversification should be introduced on products having similar production materials to eliminate the problem of businesses beginning new ventures. The company should be able to utilise similar production resources, and produce different products. Diversification could enable businesses manage price volatility occurring at the consumption end for products. Business expansion could also be utilised by various businesses seeking efficient commodity price volatility management for the raw material production perspective. Businesses involved in the conversion of commodities could consider expanding into different regions in seeking to eliminate the adverse effects of price volatility at the production stage. Businesses could establish outlets in experiencing low price volatility, as these regions make commodity conversion cheaper and stable. Expansion could enable businesses to undertake manufacturing in regions where the processes might be identified as cheaper. Conducting manufacturing in a command economy and selling within the free market economy, for example, could enable businesses beat the effects of price volatility within the free markets. Despite the existing regulation in the volume being produced within the communist societies, utilising the opportunity could enable international businesses properly manage commodity price volatility. Many factors might contribute to the presence of the high price volatility and elimination of these factors remains essential in efficient management of price volatility. Majority of these factors, however, remain external factors beyond the business control. Government policies and economic systems commonly create price volatility in commodities manufactured within various countries. Issues revolving around labour concerns could cause significant volatility in commodity prices, through changing the production costs incurred. The costs of raw materials and their price variances also affect final commodity price volatility. Though these factors cannot be eliminated by the businesses, they can be avoided through conducting business in areas with stability in material prices and minimal government policy changes. Commodity price volatility management should always include a consideration of the various aspects contributing to the occurrence of the volatility. The beginning towards efficient management of volatility remains evaluation of existing market changes in product prices at the producing, conversion and consumption stage. Following identification of the factors causing volatility, businesses implement essential structural changes aimed at minimising the effect of price volatility, upon business profitability. Risk takers normally make assumptions of the expected changes and implement methods for advancing with the business venture. Conservative investors, on the other hand, would typically seek to eliminate the factors contributing to high volatility as a way of enhancing business profitability. Increased consumer knowledge and market competition contribute significantly towards the constant flux in the pricing of many commodities, making the management of price volatility essential element of business success.6 References Aizenman, J., & Pinto, B. (2005). Managing Economic Volatility and Crises: A Practitioner's Guide. Cambridge: Cambridge University Press. Chew, L. (1996). Managing Derivative Risks: The Use and Abuse of Leverage . New York: John Wiley & Sons. Domowitz, I., Glen, J. and Madhavan, A. (2001). Liquidity, volatility and equity trading costs across countries and over time. International Finance, 4 (2): 221-255 Glosten, L. R. and Milgrom, P. R. (1985). Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, Journal of Financial Economics, 14 (1), 71-100 Jorion, P. (1995). Predicting Volatility in Foreign Exchange Market. Journal of Finance, 50 (2): 507–528 Rumelt, R. P. (1982). Diversification strategy and profitability. Strategic Management Journal, 3, (4): 359-369 Read More