Price volatility

Published on September 2, 2020 by Entrima

If prices would not move, there would be no price risk. In markets where the price level is regulated and, consequently, fixed for the remainder of the year, price volatility does not exist. As a result, there is no market risk for organisations in these markets. Only in free or liberal markets, price risk has to be considered.

The most commonly used risk parameter in investment theory or in the traded markets is price volatility. Market risk is the most common terminology applied for price risk. Market risk considers both probability and effect of prices to move adversely. Price volatility gives an indication of the capriciousness of the price movements of a physical commodity or a financial instrument over a certain period, either in history or in the future.

Price volatility is often seen as the annualised standard deviation, numerically expressed in a percentage.

Example:

Suppose that the price of an asset is 50.00 and the price volatility is said to be 40%. This means the standard deviation on an annual basis is 20.00, namely 40% of 50.00. It also implies that the current price of 50.00 is expected in a year from now to be in the range 50.00 minus 40% and 50.00 plus 40%, meaning within the range 30.00 to 70.00. Nevertheless, in a year from now, the price could, obviously, also have fallen below 30.00 or having exceeded 70.00, but this is not included in a maximum change of one standard deviation. Moreover, it would result in a change of more than one standard deviation. As one standard deviation reflects a confidence level of 68%, one can say that there is a 68% likelihood that the price of 50.00 will turn out to be in a year from now in the range 30.00 to 70.00. In other words, one can state with a confidence level of 68% that, in twelve month from now, the market will be in the range 30.00 to 70.00. It also means there is a 16% chance that the price will end up lower than 30.00 and a 16% chance that it will end up higher than 70.00.