Key Questions about Managing Risk on the Farm--Chap. 15
• What are the sources of risk that farmers face?
• What strategies do farmers use to control risks?
• How do attitude and risk bearing ability affect willingness to bear risk?
• What tools can be used to analyze risk?
Definitions
• EVENT: a happening over which we have no control
• OUTCOME: a possible result from an event
• STRATEGY: a course of action that must be taken before the outcome to an event is known
Making Risky Decisions
1. Identify a risky event
Weather during the growing season
2. Identify possible outcomes
normal or drought
3. Estimate the probability of each outcome
normal—75%, drought—25%
Must add up to 100%.
Estimating Probabilities
• From past observations
– Historical data
– Correct for trend
• Personal convictions
– Subjective judgements
– Experience
• Expert opinions
– outlook information
• Futures markets
• Decide on possible strategies
(1) plant corn
(2) plant milo
• Estimate the value of the result for each strategy and outcome combination
Gross margins: Corn Milo
normal $150 $120
drought $ 50 $ 80
• Compare the expected value for each strategy (sum each outcome x probability)
corn: ($150 x .75) + ($50 x .25) = $125
milo: ($120 x .75) + ($80 x .25) = $110
7. Compare the risk for each strategy
Range: corn $150 - $50 = $100
milo $120 - $80 = $ 40
8. Make a Decision
• If risk is not important, choose the strategy with the highest expected value.
– Corn = $125
– Milo = $115
• If we have a minimum revenue level, choose the strategy that is least likely to have a lower revenue (safety first).
• Example: Need at least $75 to make the land payment.
• Choose milo—lowest outcome is $80
Measuring Risk
Risk is measured by the variability from the expected value
– Range between the highest and lowest outcomes
– Variance and standard deviation
– Probability distributions (graphs)
– Probability of a loss
Historical Yields for Corn
Probability Distribution (Histogram)
Graph the value of each possible outcome (or range) against the probability of it occurring.
Decision Rules for Choosing Among Risky Alternatives
• Maximum expected value
(if risk neutral)
• Minimum variability
(treats highs and lows the same)
• Safety first
(lowest chance of a big loss)
Attitude Toward Risk
• Past experiences
• Size of gain or loss
• Financial security
• Age, health
• Family responsibilities
• Cultural values
Financial Ability to Bear Risk
v Solvency: debt and assets
v Liquidity: cash flow needs