Managing Risk and Uncertainty Chapter 15: Kay and Edwards

Agenda Defining Risk and Its Different Types Analysis Tools for Risk Management Tools for Risk

Risk A situation in which more than one possible outcome exists with differing payoffs, some of which may be unfavorable. Major sources of risk: Production Marketing Financial Legal Personal

Production Risk Crop and livestock performances depend heavily on biological process which can be extremely uncertain. Farmers must deal with weather, diseases, insects, weeds, and soil fertility. New technology can be another source of risk. What technology do you buy into and when?

Marketing and Price Risk Prices for commodities are usually unknown until the time of sale. Supply and demand information is unknown when making the initial production management decision. Costs of some of the inputs may be uncertain. Best method of marketing livestock and crops change from year to year.

Financial Risk Causes of financial risk: Unknown future interest rates. The lender's willingness to provide the funding levels needed for now and the future is always uncertain. Change in the market value of collateral. The ability to generate the cash flow needed to repay the loans is always uncertain.

Legal Risk Regulation related to agricultural production. Food safety Violation of laws Liability from accidents

Personal Risk Farming is a hazardous career. Employee loyalty is eroding. Family disputes and divorce can cause uncertainty.

Bearing Risk Ability to bear risk Willingness to bear risk The level of risk a farmer may take on can be limited to the farmer's financial ability for taking on risk. Willingness to bear risk The level of risk a farmer may take on also pertains to the farmer's desire to take on risk.

Important Considerations in Risky Matters Forming expectations This relates to figuring out what next year's production will likely be. Variability This pertains to the riskiness of your expectation.

Forming Expectations Most Likely Method Averages This method chooses the expectation based on what is most likely to occur. Averages Simple average Weighted/expected average

Simple Average Using this method, you collect as much historical data on what you are trying to estimate and weight each equally. Simple average = (x1 + x2 + … + xn)/n Where xi = a previous observation of what you are trying to predict, e.g., prices, yields, etc. n = number of observations. This assumes that past observations have equal weighting.

Weighted/Expected Averages This method gives different weighting to each observation. Expected average = x1*p1 + x2*p2 + … + xn*pn Where xi = past observation Where pn = the weight you place on xi

Variability This is one measure related to how risky your expectation is. Methods of measuring variability: Range Standard Deviation Coefficient of Variation

Range This examines the difference between the highest and lowest outcome. Assuming that the expected outcomes are the same, small ranges are better than large ranges. This measure does not consider any probabilities in its measurement.

Standard Deviation Standard deviation = Square root of the variance Variance = Summation (xi - xbar)2 / (n -1) over all i Where xi = observed values Where xbar = expected value Where n = number of observations A larger standard deviation indicates a greater variability of outcomes.

Coefficient of Variation (CV) CV = standard deviation / mean This measure allows for cross comparisons when the expected values are very different. Smaller coefficients indicate that the distribution is less variable.

Considerations Pertaining to Risk Identify the potential sources of risk. Identify the possible outcomes that can occur from an event. Decide on the alternative strategies available. Quantify the consequences or results of each possible outcome for each strategy. Estimate the risk and expected returns for each strategy, and evaluate the trade-off among them.

Two Tools for Examining Risk Decision Tree This is a diagram that traces out several possible management strategies, the potential outcomes from an event, and their results. Payoff Matrix A way of representing the same information from a decision tree on a contingency table.

Decision Rule for the Payoff Matrix Most Likely Outcome This decision rule chooses the outcome that has the highest probability of occurring, then chooses the strategy that maximizes the payoff. Maximum Expected Value Under this decision rule, you choose the strategy that has the highest expected payoff.

Decision Rule for the Payoff Matrix Cont. Risk and Returns Comparison This decision rule investigates both payoff and risk and is dependent upon the ability of the farmer to bear risk. Analyzing the coefficient of variation is one form of this decision rule. Maxi-Min This decision rule looks at the worst payoff for each strategy, then chooses the strategy that has the maximum payoff of these worst cases.

Decision Rule for the Payoff Matrix Cont. The appropriate decision rule will depend on the manager's attitude towards risk, the financial condition of the business, cash flow requirements, and other individual factors.

General Approaches to Risk Management Reduce the variability of possible outcomes. Set a minimum income or price level. Maintain flexibility of decision making. Improve the risk bearing ability of the business.

Production Risk Tools Stable Enterprises Diversification This tool requires that the manager choose enterprises that have proven histories of generating stable income. Diversification This tool requires the manager to have many different crops and livestock enterprises.

Production Risk Tools Cont. Insurance Life Insurance Property Insurance Liability Insurance Multiple Peril Crop Insurance (Yield Insurance) Crop Hail Insurance Revenue Insurance

Production Risk Tools Cont. Extra Production Capacity This tool requires that the manager maintain more machinery and equipment available than for a normal year. Share Leases In this case, the landowner usually pays part of the operating expenses and receives a portion of the production.

Market Risk Tools Spreading Sales Contract Sales This tool requires that the manger sell production several times a year rather than just once. Contract Sales Signing a contract with a buyer before production has occurred.

Market Risk Tools Cont. Hedging Commodity Options Using the commodity futures market to lock in a price. Commodity Options For a premium, options give you a right but not an obligation to a position in the futures market.

Financial Risk Tools Fixed Interest Rates Self-Liquidating Loans This is a loan that can be repaid from the sale of the loan collateral. Liquid Reserves This tool requires the manager to have a large cash reserve or items that can be easily turned into cash.

Financial Risk Tools Cont. Credit Reserve Never borrowing up to the credit limit from your lender. Owner Equity This tool requires that the manager steadily increase owner equity over time. Business Organization Choosing a business organization that allows the manager to shed risk as seen in chapter 14.