How to hedge price risk in a volatile market
David Becker explains how using derivatives can help protect profit margins during times of market volatility
In the last few years, we have seen prices rally quickly. Heating bills are climbing, rents are rising, and food prices are zipping higher. Unfortunately, costs can remain stubbornly high for an extended period and create market volatility. If the stock market is any guide to what will happen 9-12 months from now, the global economy could be in for a bumpy ride.
Several impetuses are creating uncertainty. The emergence from lockdowns, higher interest rates, and political unrest, to name a few. When volatility strikes, you can be forced to change your business plans, especially if you are making money on a tight budget. One way to avoid experiencing volatility is to use derivatives to lock in your profit margins.
Why have prices climbed so quickly?
Most of us were not expecting prices to blaze out of control. We all experienced lockdowns and restarts, and these events are contributing to accelerating inflation. As the world recovers from supply chain disruptions as a result of Covid-19, business cycles are changing.
The uncertainty of supply chain issues has driven up the price of most commodities worldwide. To ease the economic blow created by Covid-19, central banks around the globe cut interest rates rapidly, adding liquidity and increased price pressures. Add a touch of fiscal stimulus, and prices are off to the races.
This phenomenon has taken US consumer inflation to 40-year highs. Not only has there been a robust climb in wholesale prices, but these price spikes have also spilled over into the consumer sector, and people are complaining.
Now central banks want to tighten the noose
Many countries will start to raise interest rates to fend off higher inflation. The Bank of England has increased interest rates, and the Fed is expected to pull the trigger in March. This process works because a central bank will raise interest rates and take excess liquidity out of the economy. While the goal is not to reduce demand for goods and services, raising interest rates accomplishes this scenario. Higher interest rates make loans more expensive and restrict consumers’ access to capital. Demand destruction eventually could lead to lower prices.
During this stage of the business cycle, volatility accelerates. While volatility might not mean that you don’t achieve your profit margins, it might make the experience a rocky ride. You can see from the chart below on refined soybean oil (RBD) that historical volatility has exploded, and further changes by central banks, political unrest, along with robust global demand will likely continue to keep prices volatile.
If you have exposure to commodity prices, there are several ways that you can reduce the volatility of your returns.
Managing price risk without a futures market
Believe it or not, you can even hedge price risk without a futures market. If you are interested in the details, you can watch a recent presentation at Fastmarkets The Jacobsen’s annual conference on managing price risk without a futures market.
Remember, volatility can cut both ways. Producers and consumers should consider if the current market provides profits for years to come or if better or worse times are ahead. A company that offers over-the-counter price protection using derivatives is Stable Price. Here is a short video on how it works.
Fastmarkets offers several forecasting products on agriculture, forest products, metals and mining. We also provide price risk management techniques for over-the-counter and futures markets within our risk solutions practice.