Key Questions About Managing Risk on the Farm Chap

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