Farm Management
Chapter 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
© Mcgraw-Hill Companies, 2008
Chapter Objectives
1. Identify the sources of risk and uncertainty
2. Show how risk and uncertainty affect
decision making
3. Discuss how attitude and financial stability
affect risk
4. Illustrate ways to measure risk
5. Demonstrate methods to help make
decisions under risky conditions
6. Discuss tools to reduce risk or control its
effects
© Mcgraw-Hill Companies, 2008
Sources of Risk and Uncertainty
•
•
•
•
•
Production and technical risk
Price and market risk
Financial risk
Legal risk
Personal risk
© Mcgraw-Hill Companies, 2008
Risk-Bearing Ability and Attitude
Producers vary greatly in their willingness
to take risks and in their abilities to survive
any unfavorable outcomes of risky actions.
The level of risk a business should accept
is very much an individual decision.
© Mcgraw-Hill Companies, 2008
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. Cash
flow commitments also affect the ability
to repay loans.
© Mcgraw-Hill Companies, 2008
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, past
financial experiences, the size of
potential gains or losses, and other
factors all influence the amount
of risk producers are willing to bear.
© Mcgraw-Hill Companies, 2008
Expectations and Variability
When managers are uncertain about
the future, they often use some type
of average or “expected” values for
yields, costs or prices. There is no
assurance that the expected outcome
will be the actual outcome, but
decisions must be based on the best
information possible.
© Mcgraw-Hill Companies, 2008
Probabilities
Probabilities are useful when forming
expectations. The true probabilities for
various outcomes are seldom known,
but subjective probabilities can be
derived from whatever information is
available, plus experience and judgment
of the individual.
© Mcgraw-Hill Companies, 2008
Forming Expectations
•
•
•
•
Most likely
Averages
Expert Opinions
Futures Markets
© Mcgraw-Hill Companies, 2008
Table 15-1
Using Probabilities to Form Expectations
Possible
wheat yields
(bu/acre)
Number of years
actual yield was
in this range
Probability
0-14
15-21
22-28
29-35
36-42
43-51
Total
1
2
5
7
4
1
20
5%
10%
25%
35%
20%
5%
100%
© Mcgraw-Hill Companies, 2008
Table 15-2
Using Averages to Form an Expected Value
Year
Average
Annual Price
Weighted average
Weight
Price x Weight
5 years ago
4 years ago
3 years ago
2 years ago
Last year
$73.10
66.40
82.40
87.50
90.30
0.10
0.15
0.20
0.25
0.30
$7.31
9.96
16.48
21.88
27.09
Summation
$399.70
1.00
$82.72
Simple average = ($399.70/5) = $79.94
Weighted average = $82.72
beef cattle prices
© Mcgraw-Hill Companies, 2008
Variability
•
•
•
•
Range
Standard deviation
Coefficient of variation
Cumulative distribution function
© Mcgraw-Hill Companies, 2008
Table 15-3
Historical Corn and Soybean Yields for a Farm
Year
1
2
3
4
5
6
7
8
9
10
Mean (expected value)
Standard deviation
Coefficient of variation
Corn
(bushels/acre)
Soybeans
(bushels/acre)
145
165
161
108
125
149
138
95
152
147
138.5
22.7
0.16
45
55
48
38
43
54
50
31
47
58
46.9
8.2
0.17
© Mcgraw-Hill Companies, 2008
Table 15-4
Cumulative Probability Distributions for Yields
Corn
(bushels/acre)
Soybeans
(bushels/acre)
Cummulative
probability
(%)
95
108
125
138
145
147
149
152
161
165
31
38
43
45
47
48
50
54
55
58
5
15
25
35
45
55
65
75
85
95
© Mcgraw-Hill Companies, 2008
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
© Mcgraw-Hill Companies, 2008
Figure 15-3
Decision tree for stocker steer example
© Mcgraw-Hill Companies, 2008
Table 15-5
Payoff Matrix for Stocker Steer Problem
Purchase Strategy
Weather Outcomes Probability
Buy 300
Buy 400
Buy 500
Good
Average
Poor
$20,000
10,000
6,000
$26,000
14,000
0
$34,000
15,000
-10,000
10,800
6,000
20,000
14,000
12,200
0
26,000
26,000
11,300
-10,000
34,000
44,000
Expected Value
Minimum Value
Maximum Value
Range
0.2
0.5
0.3
© Mcgraw-Hill Companies, 2008
Decision Rules
•
•
•
•
•
Most likely outcome
Maximum expected value
Risk and returns comparison
Safety first
Break-even probability
© Mcgraw-Hill Companies, 2008
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
© Mcgraw-Hill Companies, 2008
Production Risk Tools
•
•
•
•
•
•
•
Stable enterprises
Diversification
Insurance
Extra production capacity
Share leases
Custom farming and feeding
Input procurement
© Mcgraw-Hill Companies, 2008
Table 15-6
Comparison of Specialized and Diversified
Farms
Beef cow
Net Farm Income
(average 1996-2005)
$23,853
Standard Deviation
16,940
Coefficient of Variation
0.71
Beef
backgrounding
Beef and
crop
$38,033
33,438
0.88
$27,646
14,617
0.53
Source: Kansas Farm Management Association
© Mcgraw-Hill Companies, 2008
Market Risk Tools
•
•
•
•
•
Spreading sales
Contract sales
Hedging
Commodity options
Flexibility
© Mcgraw-Hill Companies, 2008
Financial Risk Tools
•
•
•
•
•
Fixed interest rates
Self-liquidating loans
Liquid reserves
Credit reserve
Owner equity
© Mcgraw-Hill Companies, 2008
Legal Risk Tools
• Business organization
• Estate planning
• Liability insurance
© Mcgraw-Hill Companies, 2008
Personal Risk Tools
•
•
•
•
Health insurance
Life insurance
Safety precautions
Backup management
© Mcgraw-Hill Companies, 2008
Summary
We live in a world of uncertainty. Several
decision tools can be used to choose
among risky alternatives. Production,
marketing, financial, legal, and personal
risk can be reduced or controlled using
a number of techniques.
© Mcgraw-Hill Companies, 2008