Farm Management Chapter 15 Managing Risk and Uncertainty

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Farm Management Chapter 15 Managing Risk and Uncertainty farm management chapter 15

Farm Management Chapter 15 Managing Risk and Uncertainty farm management chapter 15

Chapter Outline • • • Sources of Risk and Uncertainty Risk-Bearing Ability and Attitude

Chapter Outline • • • Sources of Risk and Uncertainty Risk-Bearing Ability and Attitude Expectations and Variability Decision Making Under Risk Tools for Managing Risk farm management chapter 15 2

Chapter Objectives 1. To identify the sources of risk and uncertainty 2. To show

Chapter Objectives 1. To identify the sources of risk and uncertainty 2. To show risk and uncertainty affect decision making 3. To discuss how attitude and financial stability affect risk 4. To illustrate ways to measure risk 5. To demonstrate methods to help make decisions under risky conditions 6. To discuss tools to reduce risk or control its effects farm management chapter 15 3

Sources of Risk and Uncertainty • • • Production and technical risk Price and

Sources of Risk and Uncertainty • • • Production and technical risk Price and market risk Financial risk Legal risk Personal risk farm management chapter 15 4

Figure 15 -1 Causes of insured crop losses farm management chapter 15 5

Figure 15 -1 Causes of insured crop losses farm management chapter 15 5

Risk Bearing Ability and Attitude Producers vary greatly in their willingness to take risks

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. farm management chapter 15 6

Ability to Bear Risk Financial reserves play a big part in determining an operation’s

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. farm management chapter 15 7

Willingness to Bear Risk Some producers refuse to take risks even though they have

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. farm management chapter 15 8

Expectations and Variability When managers are uncertain about the future, they often use some

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. farm management chapter 15 9

Probabilities are useful when forming expectations. The true probabilities for various outcomes are seldom

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. farm management chapter 15 10

Forming Expectations • • Most likely Averages Expert Opinions Futures Markets farm management chapter

Forming Expectations • • Most likely Averages Expert Opinions Futures Markets farm management chapter 15 11

Table 15 -1 Using Probabilities to Form Expectations farm management chapter 15 12

Table 15 -1 Using Probabilities to Form Expectations farm management chapter 15 12

Table 15 -2 Using Averages to Form an Expected Value beef cattle prices farm

Table 15 -2 Using Averages to Form an Expected Value beef cattle prices farm management chapter 15 13

Variability • • Range Standard deviation Coefficient of variation Cumulative distribution function farm management

Variability • • Range Standard deviation Coefficient of variation Cumulative distribution function farm management chapter 15 14

Table 15 -3 Historical Corn and Soybean Yields for a Farm farm management chapter

Table 15 -3 Historical Corn and Soybean Yields for a Farm farm management chapter 15 15

Table 15 -4 Cumulative Probability Distributions for Yields farm management chapter 15 16

Table 15 -4 Cumulative Probability Distributions for Yields farm management chapter 15 16

Figure 15 -2 Cumulative distribution function for yields farm management chapter 15 17

Figure 15 -2 Cumulative distribution function for yields farm management chapter 15 17

Decision Making Under Risk 1. Identify possible sources of risk 2. Identify possible outcomes

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 farm management chapter 15 18

Figure 15 -3 Decision tree for stocker example farm management chapter 15 19

Figure 15 -3 Decision tree for stocker example farm management chapter 15 19

Table 15 -5 Payoff Matrix for Stocker Steer Problem farm management chapter 15 20

Table 15 -5 Payoff Matrix for Stocker Steer Problem farm management chapter 15 20

Decision Rules • • • Most likely outcome Maximum expected value Risk and returns

Decision Rules • • • Most likely outcome Maximum expected value Risk and returns comparison Safety first Break-even probability farm management chapter 15 21

Tools for Managing Risk 1. Reduce the variability of possible outcomes 2. Set a

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 farm management chapter 15 22

Production Risk Tools • • • Diversification Insurance Extra production capacity Share leases Custom

Production Risk Tools • • • Diversification Insurance Extra production capacity Share leases Custom farming and feeding Input procurement farm management chapter 15 23

Table 15 -6 Comparison of Specialized and Diversified Farms Source: Kansas Farm Management Association

Table 15 -6 Comparison of Specialized and Diversified Farms Source: Kansas Farm Management Association farm management chapter 15 24

Market Risk Tools • • • Spreading sales Contract sales Hedging Commodity options Flexibility

Market Risk Tools • • • Spreading sales Contract sales Hedging Commodity options Flexibility farm management chapter 15 25

Financial Risk Tools • • • Fixed interest rates Self-liquidating loans Liquid reserves Credit

Financial Risk Tools • • • Fixed interest rates Self-liquidating loans Liquid reserves Credit reserve Owner equity farm management chapter 15 26

Legal Risk Tools • Business organization • Estate planning • Liability insurance farm management

Legal Risk Tools • Business organization • Estate planning • Liability insurance farm management chapter 15 27

Personal Risk Tools • • Health insurance Life insurance Safety precautions Backup management farm

Personal Risk Tools • • Health insurance Life insurance Safety precautions Backup management farm management chapter 15 28

Summary We live in a world of uncertainty. Several decision tools can be used

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. farm management chapter 15 29

Decisions Under Risk and Uncertainty Risk vs UncertaintyDecisions Under Risk and Uncertainty Risk vs Uncertainty
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