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?

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Presentation transcript:

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

4.Decide on possible strategies (1) plant corn (2) plant milo 5.Estimate the value of the result for each strategy and outcome combination Gross margins: CornMilo normal$150$120 drought$ 50$ 80

6.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) = $ 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 1.Range between the highest and lowest outcomes 2.Variance and standard deviation 3.Probability distributions (graphs) 4.Probability of a loss

Historical Yields for Corn YearYieldYearYield

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  Solvency: debt and assets  Liquidity: cash flow needs