Price risk, in a narrow sense, means the risk associated with adverse changes in the prices of materials and raw materials for production consumed by individual companies or products and services sold by them. Unfavorable changes in these prices have specific consequences for production costs, sales revenues, profit, and ultimately also goodwill.
Although the price is one of the elements of the contract, it brings together the results of the entire company's activity in the entire market. It applies equally to importers and exporters, while the effects that it brings are different. In the export, setting too low a price means that the effectiveness of the transaction is reduced. It happens that the buyer involves a low price with poor quality of the goods, which paradoxically can lead to the phenomenon where the price reduction leads to a decrease in demand. In addition, in countries with a market economy, including in the European Union, too low a price may be considered as a dumped price, which entails the risk of initiating an anti-dumping proceeding. An analogous situation can be attributed to an importer where too high a price is tantamount to a deterioration of transaction efficiency, and too low, it can raise doubts as to the quality of the goods. In order to limit the risk, contractual clauses regarding the subject of delivery, quality parameters, warranty and possible guarantee should be properly developed.
The importance of the passage of time
A certain period of time between the moment of concluding the transaction and the moment of its implementation is characteristic for foreign trade. In order to avoid problems that this phenomenon may pose, it is possible to fix the price of the fix, which binds both parties to the contract, regardless of the level at which the market price will be shaped at the time of payment. An indirect solution is to include a price revision clause in the contract, allowing it to change in the event that the basic price components exceed the set level. Due to the passage of time between the date of conclusion and the date of performance of the contract, the price risk is closely related to the previously described exchange rate and currency risk.
The risk of a credit price is also associated with the price risk. Theoretically, it should not differ from the cash price, because it should be covered by the cost of the loan. In practice, however, it is usually higher than the cash price. This can be explained by the fact that the capital engaged in the production or trade of goods usually brings a greater profit than the same capital located in the bank. The second reason for this is the risk related to the possibility of default on payment obligations. In many countries, it is possible to hedge the credit risk by insuring export credit.
Price risk management
This is one of the most difficult tasks for exporters. Price is a complex category because it defines the value of a good or service presented in monetary units. The product has the value that the buyer will pay for it. As we know, the price is influenced by the supply and demand categories, there are also science about the mechanisms of demand and supply formation, as well as their influence on the production volume in competitive markets. The price risk in the country is so significant that the effects may be transferred to other foreign markets because they are derived from domestic prices. Therefore, a very important goal is to reduce production costs and control them, because they affect the total costs of the organization calculated for a given size of output. The above observation is very important for all entrepreneurs who export goods to foreign markets.
Tasks related to price risk management, which should be defined by an exporter who wants to examine his market situation of a given product:
- Choosing a pricing strategy for a given product
- Choosing the target market
- Technological requirements on a given market
- Expected reaction from the competition
- Maximum market participation
- Determining the amount of good that can be produced
- Setting the price level for the whole year
- Characterization of the actual level of competition prices
- Determining the expected profit
- The competition situation with regard to costs
- Defining boundaries that can limit profit
- Characterization of consumer expectations as to product prices
- Determination of the cost structure
- Taking into account further possible price thresholds
The above tasks are related to the pricing strategy, which describes the next steps in the field of risk management, consumer behavior, market definition, defining predictable maximum shares in selected markets, technical requirements that are necessary for the production of specific goods, cost analysis by which we are able to assess predictable income.
When examining the market for which we want to introduce a given product, it requires taking into account the actual situation and a statement whether there is a possibility of growth that allows increasing the transaction, as well as checking what are the expectations and requirements of the consumers for the future. The priority task is also to set the company's profitability threshold, which is not an easy task.
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- Mahul, O. (2003). Hedging price risk in the presence of crop yield and revenue insurance. European Review of Agricultural Economics, 30(2), 217-239.
- Fehr, M., & Hinz, J. (2006). A quantitative approach to carbon price risk modeling. Institute of Operations Research, ETH Zurich.