Farm Management

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Farm Management

• Chapter 15
• Managing Risk and Uncertainty

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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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Figure 15-1Causes of insured crop losses
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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.
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Ability to Bear Risk
Financial reserves play a big part in
determining an operations 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.
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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, past financial
experiences, the size of potential gains or
losses, and other factors all influence the
amount of risk producers are willing to bear.
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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.
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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.
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Forming Expectations

• Most likely
• Averages
• Expert Opinions
• Futures Markets

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Table 15-1Using Probabilities to Form
Expectations
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Table 15-2 Using Averages to Form an Expected
Value
beef cattle prices
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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
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Table 15-4Cumulative Probability Distributions
for Yields
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Figure 15-2Cumulative distribution function for
yields
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Decision Making Under Risk

• Identify possible sources of risk
• Identify possible outcomes that can occur from an
  event
• List the strategies available
• Quantify the consequences or results of each
  possible outcome
• Estimate the risk and expected returns for each
  strategy

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Figure 15-3Decision tree for stocker example
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Table 15-5Payoff Matrix for Stocker Steer Problem
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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

• 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

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Production Risk Tools

• 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
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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.
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.
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1. List a least five sources of risk and
uncertainty for farmers in your area. Classify
them as production, price, financial, legal, or
personal risk. Which are the most important?
Why?

• Typical answers could include various weather
  factors, disease and other pests, genetics, price
  variability, input costs, government actions, and
  personal health conditions. The specific factors
  mentioned and the relative importance attached to
  them will depend on the local climatic and
  economic conditions and the student's own values
  and experiences.

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2. How might a young farmer with heavy debt view
risk, compared with an older, established farmer
with little debt?

• The younger farmer would likely be less inclined
  to take risky actions, or would take actions that
  would protect against the consequences of an
  unfavorable event happening.

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3. Might these same two farmers have different
ideas about the amount of insurance they need?
Why?

• The younger farmer would probably feel the need
  for more insurance coverage because one major
  loss might be enough to cause termination of the
  farm business.

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4. How do subjective probabilities differ from
true probabilities? What sources of information
are available to help form them?

• Subjective probabilities are formed from past
  experience and personal expectations about future
  events, rather than statistical evidence. The
  latter can be used to estimate true probabilities
  given enough data. Information sources include
  past record data, outlook information, and crop
  and livestock forecasts.

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7. Identify the steps in making a risky decision,
and give an example.

• (1) Identify the possible sources of risk, (2)
  identify the possible outcomes, (3) decide on
  alternative strategies available, (4) quantify
  the possible results of each strategy and
  possible outcome, (5) estimate the risk and
  expected returns, and evaluate the trade-offs.

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• 1) volatile grain markets
• 2) grain prices may fall or rise from planting
  to harvest
• 3) forward price, hedge, buy put options, buy
  revenue insurance, do nothing
• 4) estimate the costs and returns for each
  strategy under both higher and lower prices
• 5) find the expected value for each alternative,
  and the probability of a loss

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10. Give two examples of risk management
strategies that fall into each of the following
general categories

• a. Reduce the range of possible outcomes
• crop share or livestock share lease
  diversification of enterprises, seed varieties or
  hybrids, or breeding stock spreading sales
  throughout the year hedging contract or custom
  production.
• b. Guarantee a minimum result for a fixed cost
• Any type of insurance buying commodity options
  using a CCC price support loan.
• c. Increase flexibility of decision making

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11. Describe one important risk management tool
or strategy that will help cope with each of the
following types of risk on a ranch or farm.

• a. Production crop insurance, livestock
  vaccination, planting multiple varieties,
  applying pesticides.
• b. Market spreading sales, forward contracts,
  futures and options contracts, revenue insurance
• c. Financial fixed interest rates, credit
  reserve, working capital
• d. Legal limited liability business entity,
  liability insurance, having a will, following
  environmental regulations
• e. Human medical and life insurance,
  maintaining good personal health, backup labor
  and management