Key Questions about Managing
Risk on the Farm--Chap. 15
• What are the sources of risk
that farmers face?
• What strategies do farmers use to
control risks?
• How do attitude and risk bearing ability
affect willingness to bear risk?
• What tools can be used to analyze risk?
Definitions
• EVENT: a happening over which we
have no control
• OUTCOME: a possible result from an
event
• STRATEGY: a course of action that must
be taken before the outcome to an
event is known
Making Risky Decisions
1. Identify a risky event
Weather during the growing season
2. Identify possible outcomes
normal or drought
3. Estimate the probability of each
outcome
normal—75%, drought—25%
Must add up to 100%.
Estimating Probabilities
• From past observations
– Historical data
– Correct for trend
• Personal convictions
– Subjective judgements
– Experience
• Expert opinions
– outlook information
• Futures markets
4. Decide on possible strategies
(1) plant corn
(2) plant milo
5. Estimate the value of the result for each
strategy and outcome combination
Gross margins: Corn
normal
$150
drought
$ 50
Milo
$120
$ 80
6. Compare the expected value for each
strategy (sum each outcome x probability)
corn: ($150 x .75) + ($50 x .25) = $125
milo: ($120 x .75) + ($80 x .25) = $110
7. Compare the risk for each strategy
Range: corn
milo
$150 - $50 = $100
$120 - $80 = $ 40
8. Make a Decision
• If risk is not important, choose the strategy
with the highest expected value.
– Corn = $125
– Milo = $115
• If we have a minimum revenue level, choose
the strategy that is least likely to have a
lower revenue (safety first).
• Example: Need at least $75 to make the land
payment.
• Choose milo—lowest outcome is $80
Measuring Risk
Risk is measured by the variability
from the expected value
1. Range between the highest and
lowest outcomes
2. Variance and standard deviation
3. Probability distributions (graphs)
4. Probability of a loss
Historical Yields for Corn
Year
1
2
3
4
5
6
7
8
9
10
Yield
124
145
141
88
105
159
138
75
132
147
Year
11
12
13
14
15
16
17
18
19
20
Yield
51
152
178
144
160
111
143
122
180
148
Probability Distribution (Histogram)
Graph the value of each possible outcome (or
range) against the probability of it occurring.
40%
Corn Yield
30%
20%
10%
0%
5075
75100
100- 125- 150125 150 175
175
+
Decision Rules for Choosing
Among Risky Alternatives
• Maximum expected value
(if risk neutral)
• Minimum variability
(treats highs and lows the same)
• Safety first
(lowest chance of a big loss)
Attitude Toward Risk
• Past experiences
• Size of gain or loss
• Financial security
• Age, health
• Family responsibilities
• Cultural values
Financial Ability to Bear Risk
Solvency: debt and assets
Liquidity: cash flow needs