1. Managing Risk and Uncertainty
Chapter 15: Kay and Edwards

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

3. 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

4. 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?

5. 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.

6. 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.

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

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

9. 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.

10. 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.

11. 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

12. 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.

13. 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

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

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

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

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.