What Are the Risks? How Can I Manage Them?

What is Risk? RISICARE – Origin of word Risk – Italian word – “TO DARE” Risk implies – Element of choice – Action-oriented – Potential Reward as well as Potential Loss Manageable!

But how is risk manageable? Choices – Good vs. Bad Outcomes – Good vs. Bad Where can you make a difference?

What do we mean by “riskier”? Higher likelihood of bad occurrence Larger magnitude of loss (or gain) Expected value (equals magnitude times probability)

Risk Management: A Road Map Adapted from Hardaker et. al. Business Environment Define Risks Assess Risks Manage Risks Monitor and Review

Categorizing Risk Production risk Market risk Legal/institutional risk Human relations risk Financial risk

Risk: What does it mean? Write down the business environment in which your farm operates? What are the Top 10 risks you face? Place the risks into the five categories.

Adapted from Hardaker et. al. Business Environment Define Risks Assess Risks Manage Risks Monitor and Review Risk Management: A Road Map

Assessing Risk Assess Risk Generate Tactics Assign Likelihood & Consequence Use Decision Tools

How can we manage risk? Avoidance Reduction Transfer Assumption

Avoidance Planning activities or structuring the business so that risks are avoided. Football: “Call for a fair catch.” Ag. Example: supplying your own forage for a dairy operation to eliminate quality problems. Watch Out! An avoidance tactic can generate a whole new set of risks in its place.

Reduction Taking action to reduce the uncertainty of the crop, livestock or horticultural outcome. “Use Your Blockers” Ag. Examples: – Preventative maintenance on machinery – Diversification – to smooth income.

Transfer The act of shifting risk to another. “Handing the Ball Off” Ag. example: Singing a contract for a particular output price. What does this mean in terms of the risk/return trade-off?

Assumption/Retention Recognizing and accepting risk that would have been borne by another party. “Run with the Ball” Ag. example: A contractor retaining ownership of and contracting with growers to finish hogs.

How do we use the tactics? Formulate the Tactic for the Farm Business – Avoidance – Reduction – Assumption – Transfer

Which Tactic to Adopt? Depends on: – Your preference for risk – The farm’s ability to handle risk – The uncertainty of the outcome – The size of the gain or loss relative to cost

Assessing Risk Assess Risk Generate Tactics Assign Likelihood & Consequence Use Decision Tools

Probability – How Likely? Coin Flip: – 50% chance of heads, 50% chance of tails – Outcome = Heads – Likelihood = 50% Tomorrow’s Weather – 65% chance of rain – Outcome? Likelihood?

Assessments: Subjective Measures Subjective - assessment based on our own experience and intuition. Likelihood: “likely,” “almost never,” “75%” Outcome: “minor” “catastrophic” “$50,000”

Assessments: Objective Measures Objective – Use mathematics or statistical models to assess a probability and likelihood of an event. Likelihood: “50% Chance Price < Loan” “5% Chance Deviate from Trend” Outcome: $$$

Objective Assessment: MBC Farms Corn Yields Average Yield: 139.3bu.Std. Dev bu.

MBC Farms Corn Yields

What are the key points? Using the “average” outcome can be misleading – especially in a budgeting process. Deviations around the average are one way to understand how variable an outcome is. Understanding trends can help make a more realistic forecast. How can the average and standard deviation be useful?

Question: What do you prefer? Alternative Plans Average Net Revenue Std. Dev. Net Revenue Plan A$100 per day$5 per day Plan B$ 95 per day$ 10 per day

Average Comparisons Most people prefer more to less – so a higher average Most people prefer less variability in revenue to more variability. So an alternative with a higher average and lower variability might be preferred to a lower mean and higher variability. (beware the downside!) But decisions are not always this simple – unfortunately, the alternatives with high average revenues are often accompanied by high variability too.

Alternative Plans Average Net Revenue Std. Dev. Net Revenue Plan A$100 per day$10 per day Plan B$ 95 per day$ 5 per day Question: Which do you prefer?

How do we use an average and standard deviation? Compare the alternatives in pairs based on their average and standard deviation. If an alternative has a higher average and a lower standard deviation, then it is a preferred alternative. Group the preferred alternatives together and then discard those that aren’t in a preferred set.

But … Sometimes we’re not interested in just the average or overall variability of an alternative. Rather, we need to worry about the worst (or best!) that can happen. In this case, an entire distribution of returns is important. In addition, looking at a distribution of returns might help sort out alternatives which you can’t choose between based on averages and standard deviation.

Another Measure: The Probability Distribution A way to characterize all of the possible outcomes for our crop yields, or revenues or other uncertain events. The probability distribution gives both the outcome and the likelihood (probability) of an event for the entire range of feasible possibilities.

Historical Corn Prices

Corn Price Frequency: Monthly Prices Sept April 1999 Percent frequency Corn price per bushel

Cumulative Historical Frequency: Monthly Corn Prices Sept April 1999 Percent frequency Corn price per bushel

Exercise Build a Frequency The best way to learn is to do – let’s take a look at Smith Farms hay/beef cattle enterprise.

One Way to Use A Cumulative Frequency Using historical data, forward looking forecast, or subjective analysis, assign outcomes or probabilities to build the frequency Choose a “critical value” and assess the likelihood of reaching it. Based on the likelihood of reaching the critical value, the consequences of failing to meet the critical value, and your preference for risk, choose an alternative.

What’s Left Out? In our example, there was just one uncertain variable – the amount if hay needed. In reality, hay production, the amount horse owners are willing to pay, and the forecast of what it would cost to buy hay later would all factor in the decision. We can use computer software (like AgRisk®) to handle many random variables, but the concept of choosing critical values doesn’t change. In these cases, we might us the computer software to build net revenue distributions.

How else can you use cumulative distributions? Does it make sense to pre-pay our inputs (e.g. fertilizer this year)? Can I meet the production standards (e.g., rate of gain) in the proposed hog feeding contract? Do we really need to add an employee for harvest/planting (how likely are we to be that we are short of help, what’s the value of the crop, how much does the employee cost)?

Strategic Business Planning for Commercial Producers