© Mcgraw-Hill Companies, 2008 Farm Management Chapter 15 Managing Risk and Uncertainty.
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© Mcgraw-Hill Companies, 2008 Farm Management Chapter 15 Managing Risk and Uncertainty
Transcript of © Mcgraw-Hill Companies, 2008 Farm Management Chapter 15 Managing Risk and Uncertainty.
© Mcgraw-Hill Companies, 2008
Farm ManagementChapter 15
Managing Risk and Uncertainty
© Mcgraw-Hill Companies, 2008
Chapter Outline
• Sources of Risk and Uncertainty
• Risk-Bearing Ability and Attitude
• Expectations and Variability
• Decision Making Under Risk
• Tools for Managing Risk
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Chapter Objectives1. Identify the sources of risk and uncertainty2. Show how risk and uncertainty affect
decision making3. Discuss how attitude and financial stability
affect risk4. Illustrate ways to measure risk5. Demonstrate methods to help make
decisions under risky conditions6. Discuss tools to reduce risk or control its
effects
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Sources of Risk and Uncertainty
• Production and technical risk
• Price and market risk
• Financial risk
• Legal risk
• Personal risk
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Risk-Bearing Ability and Attitude
Producers vary greatly in their willingnessto take risks and in their abilities to surviveany unfavorable outcomes of risky actions.The level of risk a business should acceptis very much an individual decision.
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Ability to Bear Risk
Financial reserves play a big part in determining an operation’s risk bearing ability. Farms with a large amount of capital can withstand larger losses before becoming insolvent. Cashflow commitments also affect the abilityto repay loans.
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Willingness to Bear Risk
Some producers refuse to take risks even though they have no debt and a strong cash flow. Age,equity, financial commitment, pastfinancial experiences, the size ofpotential gains or losses, and otherfactors all influence the amountof risk producers are willing to bear.
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Expectations and Variability
When managers are uncertain aboutthe future, they often use some typeof average or “expected” values for yields, costs or prices. There is noassurance that the expected outcomewill be the actual outcome, but decisions must be based on the bestinformation possible.
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Probabilities
Probabilities are useful when forming expectations. The true probabilities forvarious outcomes are seldom known, but subjective probabilities can be derived from whatever information is available, plus experience and judgment of the individual.
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Forming Expectations
• Most likely
• Averages
• Expert Opinions
• Futures Markets
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Table 15-1Using Probabilities to Form Expectations
Possible Number of yearswheat yields actual yield was(bu/acre) in this range Probability
0-14 1 5%15-21 2 10%22-28 5 25%29-35 7 35%36-42 4 20%43-51 1 5%Total 20 100%
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Table 15-2 Using Averages to Form an Expected Value
beef cattle prices
AverageYear Annual Price Weight Price x Weight
5 years ago $73.10 0.10 $7.314 years ago 66.40 0.15 9.963 years ago 82.40 0.20 16.482 years ago 87.50 0.25 21.88Last year 90.30 0.30 27.09
Summation $399.70 1.00 $82.72
Weighted average
Weighted average = $82.72Simple average = ($399.70/5) = $79.94
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Variability
• Range
• Standard deviation
• Coefficient of variation
• Cumulative distribution function
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Table 15-3 Historical Corn and Soybean Yields for a Farm
Corn SoybeansYear (bushels/acre) (bushels/acre)
1 145 452 165 553 161 484 108 385 125 436 149 547 138 508 95 319 152 4710 147 58Mean (expected value) 138.5 46.9Standard deviation 22.7 8.2Coefficient of variation 0.16 0.17
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Table 15-4Cumulative Probability Distributions for Yields
CummulativeCorn Soybeans probability
(bushels/acre) (bushels/acre) (%)
95 31 5108 38 15125 43 25138 45 35145 47 45147 48 55149 50 65152 54 75161 55 85165 58 95
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Decision Making Under Risk
1. Identify possible sources of risk
2. Identify possible outcomes that can occur from an event
3. List the strategies available
4. Quantify the consequences or results of each possible outcome
5. Estimate the risk and expected returns for each strategy
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Figure 15-3Decision tree for stocker steer example
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Table 15-5Payoff Matrix for Stocker Steer Problem
Weather Outcomes Probability Buy 300 Buy 400 Buy 500
Good 0.2 $20,000 $26,000 $34,000Average 0.5 10,000 14,000 15,000Poor 0.3 6,000 0 -10,000
Expected Value 10,800 12,200 11,300Minimum Value 6,000 0 -10,000Maximum Value 20,000 26,000 34,000Range 14,000 26,000 44,000
Purchase Strategy
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Decision Rules
• Most likely outcome
• Maximum expected value
• Risk and returns comparison
• Safety first
• Break-even probability
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Tools for Managing Risk
1. Reduce the variability of possible outcomes
2. Set a minimum income or price level
3. Maintain flexibility of decision making
4. Improve the risk-bearing ability of the business
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Production Risk Tools
• Stable enterprises
• Diversification
• Insurance
• Extra production capacity
• Share leases
• Custom farming and feeding
• Input procurement
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Table 15-6Comparison of Specialized and Diversified
Farms
Source: Kansas Farm Management Association
Beef Beef andBeef cow backgrounding crop
Net Farm Income(average 1996-2005) $23,853 $38,033 $27,646Standard Deviation 16,940 33,438 14,617Coefficient of Variation 0.71 0.88 0.53
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Market Risk Tools
• Spreading sales
• Contract sales
• Hedging
• Commodity options
• Flexibility
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Financial Risk Tools
• Fixed interest rates
• Self-liquidating loans
• Liquid reserves
• Credit reserve
• Owner equity
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Legal Risk Tools
• Business organization
• Estate planning
• Liability insurance
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Personal Risk Tools
• Health insurance
• Life insurance
• Safety precautions
• Backup management
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Summary
We live in a world of uncertainty. Severaldecision tools can be used to chooseamong risky alternatives. Production,marketing, financial, legal, and personalrisk can be reduced or controlled usinga number of techniques.
