RISK MANAGEMENT DIVERSIFICATION DIVERSIFICATION MARKETING ALTERNATIVES MARKETING ALTERNATIVES FLEXIBILITY FLEXIBILITY CREDIT RESERVES CREDIT RESERVES INSURANCE INSURANCE

DIVERSIFICATION IT MAY BE POSSIBLE TO REDUCE THE TOTAL VARIABILITY OF RETURNS BY COMBINING SEVERAL ASSETS, ENTERPRISES, OR INCOME- GENERATING ACTIVITIES WITHOUT UNDULY SACRIFICING EXPECTED RETURNS. IT MAY BE POSSIBLE TO REDUCE THE TOTAL VARIABILITY OF RETURNS BY COMBINING SEVERAL ASSETS, ENTERPRISES, OR INCOME- GENERATING ACTIVITIES WITHOUT UNDULY SACRIFICING EXPECTED RETURNS.

HOLDING A COMBINATION OF INVESTMENTS IS CALLED DIVERSIFICATION HOLDING A COMBINATION OF INVESTMENTS IS CALLED DIVERSIFICATION A PORTFOLIO REFERS TO A MIX OR COMBINATION OF ASSETS, ENTERPRISES, OR INVESTMENTS A PORTFOLIO REFERS TO A MIX OR COMBINATION OF ASSETS, ENTERPRISES, OR INVESTMENTS

LETS LOOK AT AN EXAMPLE OF DIVERSIFICATION AN INVESTOR IS EVALUATING TWO FARM UNITS, ONE LOCATED IN THE CORN BELT AND THE OTHER LOCATED IN THE GREAT PLAINS. EACH FARM HAS AN EXPECTED RETURN ON ASSETS OF 20% AND A STANDARD DEVIATION OF RETURNS OF 10%

THEREFORE, THE INVESTOR WOULD BE INDIFFERENT BETWEEN THE TWO FARMS. HOWEVER, SINCE THE TWO FARMS ARE LOCATED IN DIFFERENT REGIONS AND HAVE A DIFFERENT MIX OF ENTERPRISES A COMBINATION OF INVESTMENT IN THE TWO FARMS MIGHT PROVIDE AN ADVANTAGE IN RISK

THE PORTFOLIO MODEL A PORTFOLIO'S EXPECTED RETURN IS THE WEIGHTED AVERAGE OF THE INDIVIDUAL EXPECTED RETURNS WEIGHTED BY THE PERCENT OF INVESTMENT IN EACH A PORTFOLIO'S EXPECTED RETURN IS THE WEIGHTED AVERAGE OF THE INDIVIDUAL EXPECTED RETURNS WEIGHTED BY THE PERCENT OF INVESTMENT IN EACH R T = r 1 P 1 + r 2 P 1

A PORTFOLIO'S TOTAL VARIANCE IS THE SUM OF THE INDIVIDUAL PROPORTIONAL VARIANCES PLUS (OR MINUS) THE COVARIANCE σ T 2 = σ 1 2 P σ 2 2 P P 1 P 2 c σ 1 σ 2 σ1σ1σ1σ1

WHERE: R T IS THE PORTFOLIO EXPECTED RETURN r i IS THE EXPECTED RETURN FOR EACH INVESTMENT P i IS THE PROPORTION OF INVESTED IN EACH INVESTMENT σ T 2 IS THE PORTFOLIO VARIANCE σ i IS THE STANDARD DEVIATION FOR EACH INVESTMENT c IS THE CORRELATION COEFFICIENT BETWEEN RETURNS FOR EACH INVESTMENT.

IF WE ASSUME THAT THE PROPORTION INVESTED IN EACH FARM IS 50% AND THE CORRELATION BETWEEN RETURNS IS 0.5 WHAT WOULD BE THE PORTFOLIO EXPECTED RETURN AND STANDARD DEVIATION?

THE EXPECTED PORTFOLIO RETURN WOULD BE: R T = (0.20)(0.5) + (0.20)(0.5) = 0.20

THE EXPECTED PORTFOLIO VARIANCE WOULD BE: σ T 2 = (0.10) 2 (0.50) 2 + (0.10) 2 (0.50) (0.50) (0.50) (0.50) (0.10) (0.10) = (0.0025) + (0.0025) + (0.0025) = σ T = or 8.66%

THE KEY COMPONENT WITH REGARD TO CONSTRUCTING A PORTFOLIO THAT REDUCES RISK WHILE MAINTAINING RETURN IS THE CORRELATION COEFFICIENT BETWEEN RETURNS FOR THE INVESTMENTS

CORRELATION OF RETURNS THE VALUE OF THE CORRELATION COEFFICIENT BETWEEN THE RETURNS OF INVESTMENTS “c” CAN TAKE ON A VALUE BETWEEN -1 ≤ c ≤ 1

PORTFOLIO VARIANCE FOR DIFFERENT VALUES OF “c” c = -1 σ T 2 = σ 1 2 P σ 2 2 P P 1 P 2 σ 1 σ 2 c = 0 σ T 2 = σ 1 2 P σ 2 2 P 2 2 c = 1 σ T 2 = σ 1 2 P σ 2 2 P P 1 P 2 σ 1 σ 2

USING THE PREVIOUS EXAMPLE IF c = -1: σ T 2 = (0.10) 2 (0.50) 2 + (0.10) 2 (0.50) (0.50) (0.50) (-1.0) (0.10) (0.10) = (0.0025) + (0.0025) - (0.005) = 0.0 σ T = 0.0%

USING THE PREVIOUS EXAMPLE IF c = 0: σ T 2 = (0.10) 2 (0.50) 2 + (0.10) 2 (0.50) (0.50) (0.50) (0.0) (0.10) (0.10) = (0.0025) + (0.0025) = σ T = 7.07%

USING THE PREVIOUS EXAMPLE IF c = 1: σ T 2 = (0.10) 2 (0.50) 2 + (0.10) 2 (0.50) (0.50) (0.50) (1.0) (0.10) (0.10) = (0.0025) + (0.0025) = 0.01 σ T = 10.00%

Risk Profits AB C D EF GH RISK – RETURN TRADE 0FF

WHAT IS TERMED A RISK EFFICIENT SET OF PORTFOLIOS IS COMPOSED OF PORTFOLIOS OF ASSETS THAT MINIMIZE VARIANCE FOR DIFFERENT LEVELS OF EXPECTED RETURNS THE PORTFOLIOS IN THE PRECEDING GRAPH OF THE RISK- RETURN TRADE OFF ILLUSTRATES THE CONCEPT OF RISK EFFICIENCY

PORTFOLIO “A” DOMINATES PORTFOLIO “C” FOR RETURN AND PORTFOLIO “B” FOR RISK PORTFOLIOS “A” “D” “G” AND “H” REPRESENT PORTFOLIOS THAT LIE ON THE RISK EFFICIENT FRONTIER WHICH GIVES THE HIGHEST RETURN FOR A GIVEN LEVEL OF RISK

ENTERPRISE DIVERSIFICATION IN AGRICULTURE DIVERSIFYING AMONG SEVERAL FARM ENTERPRISES AND EVEN BETWEEN FARM AND NON-FARM ACTIVITIES IS A TRADITIONAL APPROACH TO RISK MANAGEMENT IN AGRICULTURE

THIS TYPE OF DIVERSIFICATION IS BASED ON THE PREMISE THAT THERE IS A LOW OR NEGATIVE CORRELATION OF RETURNS AMONG SOME ENTERPRISES THAT WILL STABILIZE TOTAL RETURNS OVER TIME.

A CONSIDERATION WITH ENTERPRISE DIVERSIFICATION IS THE LOSS OF EFFICIENCIES AND RETURNS THAT MAY BE DERIVED FROM SPECIALIZATION.

MARKETING ALTERNATIVES THE USE OF HEDGING, OPTIONS, AND FORWARD CONTRACTING ARE TOOLS THAT CAN BE USED TO MANAGE RISK FOR BOTH OUTPUT PRICES AND INPUT PRICES. MARKETING POOLS, SUCH AS THE PCCA COTTON MARKETING POOL, CAN ALSO PROVIDE A USEFUL MARKETING ALTERNATIVE.

FLEXIBILITY FLEXIBILITY IN A BUSINESS ORGANIZATION ENABLES THE MANAGER TO RESPOND MORE QUICKLY AS NEW INFORMATION BECOMES AVAILABLE TO THE FIRM.

FLEXIBILITY DOES NOT DIRECTLY REDUCE RISK, BUT PROVIDES A MEANS OF COPING WITH RISK. EXAMPLES OF FLEXIBILITY ARE: REDUCING FIXED COSTS RELATIVE TO VARIABLE COSTS. REDUCING FIXED COSTS RELATIVE TO VARIABLE COSTS. CHOOSING NONSPECIFIC RESOURCES IN PLACE OF SPECIFIC RESOURCES. CHOOSING NONSPECIFIC RESOURCES IN PLACE OF SPECIFIC RESOURCES. MANAGERS THAT ARE WILLING TO MAKE CHANGES WHEN NEEDED OR AS CONDITIONS WARRANT MANAGERS THAT ARE WILLING TO MAKE CHANGES WHEN NEEDED OR AS CONDITIONS WARRANT

FLEXIBILITY HAS SOME OF THE SAME PROBLEMS AS WITH DIVERSIFICATION IN THAT BEING FLEXIBLE MAY ENTAIL LESS SPECIALIZATION AND THE GAINS IN EFFICIENCIES.

CREDIT RESERVES A CREDIT RESERVE IS A SOURCE OF LIQUIDITY. A CREDIT RESERVE IS A SOURCE OF LIQUIDITY. A FIRM’S CREDIT RESERVE IS REPRESENTED BY ITS UNUSED BORROWING CAPACITY. A FIRM’S CREDIT RESERVE IS REPRESENTED BY ITS UNUSED BORROWING CAPACITY. THE DIFFERENCE BETWEEN THE MAXIMUM AMOUNT OF POTENTIAL BORROWING AND THE AMOUNT ALREADY BORROWED IS THE CREDIT RESERVE. THE DIFFERENCE BETWEEN THE MAXIMUM AMOUNT OF POTENTIAL BORROWING AND THE AMOUNT ALREADY BORROWED IS THE CREDIT RESERVE.

IN GENERAL, CREDIT IS CONSIDERED A HIGHLY EFFICIENT WAY TO PROVIDE LIQUIDITY. IN GENERAL, CREDIT IS CONSIDERED A HIGHLY EFFICIENT WAY TO PROVIDE LIQUIDITY. USING CREDIT DOES NOT DISTURB A FIRM’S BASIC ASSET STRUCTURE AND PRODUCTION ORGANIZATION. USING CREDIT DOES NOT DISTURB A FIRM’S BASIC ASSET STRUCTURE AND PRODUCTION ORGANIZATION. TRANSACTIONS COSTS OF CREDIT ARE RELATIVELY LOW. TRANSACTIONS COSTS OF CREDIT ARE RELATIVELY LOW. CREDIT IS GENERALLY AVAILABLE. CREDIT IS GENERALLY AVAILABLE.

INSURANCE INSURANCE PROVIDES A SPECIALIZED FORM OF LIQUIDITY, INSTEAD OF RESERVING CASH, SAVINGS OR CREDIT TO COUNTER LOSSES DUE TO EVENTS SUCH AS HAIL OR CAUSALITY LOSS INSURANCE PROVIDES A SPECIALIZED FORM OF LIQUIDITY, INSTEAD OF RESERVING CASH, SAVINGS OR CREDIT TO COUNTER LOSSES DUE TO EVENTS SUCH AS HAIL OR CAUSALITY LOSS INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS. INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS.

INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS.