Suppose I want to sell roasted coffee, accepting payments in bitcoins.
My raw material is priced in USD. Bitcoin to usd is pretty volatile, and I eventually have to pay for the commodity in USD, what is the best way to set the price in bitcoin?
Any other ideas?
You set the price and include some risks in it, of course. However, the question is how you want to reduce the risk of BTC going down compared to USD.
In fact, exactly this problems drives my development of the derivatives market in the bitcoin (ICBIT, there is a thread about it in Projects Development area of the forum).
So when the derivatives market is open, you would do the following. You accept the payment for the coffee in bitcoins, say, you get 100 BTC for the coffee bag you sold. And you would need to pay 100 USD for this amount to your supplier.
As long as the rate is e.g. 2 USD per 1 BTC, you're doing good. But what if it goes to 0.5 USD per 1 BTC? You're screwed.
The solution. You buy 1 lot of the nearest USDBTC futures contract (which has a size of 100 USD) at the current price level (for exchange ratio 2 usd for 1 btc it would be around 50 BTC for 1 contract). Shortselling or buying the futures contract is a cheap operation, you just have to support the minimum maintenance margin available in your account (say, about 10% of the value, which would roughly be 5 BTC).
Now, you have: 100 BTC, 1 futures contract to hedge the risk for 100 USD you need to pay.
Imagine bitcoin rate went down (bitcoins are becoming cheaper) to 1 USD per 1 BTC. Futures price level would increase then to around 100 BTC for 1 contract, and you will get a positive variation margin in the derivatives market.
The "physical value" of the above is that the size of this variation margin transferred would be as much as it's needed to buy 100 USD on an exchange. So if the rate drops, you always have enough money to buy those 100 USD.
Of course, if the BTC value rises, variation margin will be subtracted, but since you own those 100 BTC, their value also increases, so in practice you don't loose anything.
A bit hard to explain in one topic post, but that's a classical hedging scheme, explained in every economic book out there