1. © Mcgraw-Hill Companies, 2008 Farm Management Chapter 15 Managing Risk and Uncertainty

2. © 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

3. © 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

4. © Mcgraw-Hill Companies, 2008 Sources of Risk and Uncertainty Production and technical risk Price and market risk Financial risk Legal risk Personal risk

5. © 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.

6. © 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.

7. © 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.

8. © 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.

9. © 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.

10. © Mcgraw-Hill Companies, 2008 Forming Expectations Most likely Averages Expert Opinions Futures Markets

11. © Mcgraw-Hill Companies, 2008 Table 15-1 Using Probabilities to Form Expectations

12. © Mcgraw-Hill Companies, 2008 Table 15-2 Using Averages to Form an Expected Value beef cattle prices

13. © Mcgraw-Hill Companies, 2008 Variability Range Standard deviation Coefficient of variation Cumulative distribution function

14. © Mcgraw-Hill Companies, 2008 Table 15-3 Historical Corn and Soybean Yields for a Farm

15. © Mcgraw-Hill Companies, 2008 Table 15-4 Cumulative Probability Distributions for Yields

16. © 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

17. © Mcgraw-Hill Companies, 2008 Figure 15-3 Decision tree for stocker steer example

18. © Mcgraw-Hill Companies, 2008 Table 15-5 Payoff Matrix for Stocker Steer Problem

19. © Mcgraw-Hill Companies, 2008 Decision Rules Most likely outcome Maximum expected value Risk and returns comparison Safety first Break-even probability

20. © 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

21. © Mcgraw-Hill Companies, 2008 Production Risk Tools Stable enterprises Diversification Insurance Extra production capacity Share leases Custom farming and feeding Input procurement

22. © Mcgraw-Hill Companies, 2008 Table 15-6 Comparison of Specialized and Diversified Farms Source: Kansas Farm Management Association

23. © Mcgraw-Hill Companies, 2008 Market Risk Tools Spreading sales Contract sales Hedging Commodity options Flexibility

24. © Mcgraw-Hill Companies, 2008 Financial Risk Tools Fixed interest rates Self-liquidating loans Liquid reserves Credit reserve Owner equity

25. © Mcgraw-Hill Companies, 2008 Legal Risk Tools Business organization Estate planning Liability insurance

26. © Mcgraw-Hill Companies, 2008 Personal Risk Tools Health insurance Life insurance Safety precautions Backup management

27. © 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.