Risk and Risk Management Barry J. Barnett Department of Agricultural Economics What is Risk? Reduction in annual net income caused by: Loss of revenue Low yields, low prices Change in government programs Increase in costs Higher input costs Higher interest rates Change in government regulations 2 1
What is Risk? Reduction in net worth caused by: Loss of assets Buildings, equipment, other farm improvements Death or disability of human assets Reduction in asset value Farmland Increase in liabilities Adverse outcomes from litigation 3 Is Risk Always Bad? Risk is positively related to return. Compare expected returns on stock market investments to returns on a savings account. Entrepreneurship is inherently risky. The objective is not to eliminate all risk but to manage one s exposure to risk. 4 2
Unique Aspects of Risk in the Mid-South For corn and soybeans our yield and quality risks are higher than in the Midwest. Price and yield are unrelated. Compare to Midwest. Our revenue risk is higher. Our crops are more management intensive than those in the Midwest. 5 Risk Inventory Prerequisites: Know your cost of production. Know your cash flow position. Know your balance sheet position. 6 3
Risk Inventory What loss events might I experience? What is the likelihood of the loss event? What is the potential magnitude of loss? What is my capacity for absorbing the potential loss? Recall that multiple loss events may occur simultaneously. 7 What are the Major Risks You or Your Producers Face? 8 4
How Much Risk Should I Take? Different people have different risk tolerances. Different financial situations. Different psychological tolerances for risk. Risk management implies choosing those enterprises and management strategies that conform to one s risk and return objectives. 9 Why I Don t Manage Risk! Life would be dull without fear. It s fun to keep my lender guessing. Crop failures build character. My kids would just fight over my estate. There is no free cap or jacket. The Lake Wobegon effect Where all the women are strong, all the men are good-looking, and all the children are above average. 10 5
Risk Management In general, there are three different approaches to managing risk: Risk reduction Risk transfer Risk assumption 11 Risk Reduction Diversification (both income sources and assets). Off-farm farm income. Input choices (irrigation, seed varieties, pest management, etc.). Safety training and guidelines for employees. Farm business as separate, limited liability, legal entity. 12 6
Risk Transfer Insurance Life Health Disability Liability Property Crop yield or revenue insurance Forward pricing i 13 Price Risk Management vs. Speculation Should producers (and their economist advisors) be trying to beat Chicago or New York by speculating on future market moves? Or, should they simply be using commodity exchange markets to offset the price risk inherent in being long the commodity? Some think they can do both simultaneously, but it seems doubtful that one can consistently accomplish both objectives over the long-term. 14 7
Price Risk Management vs. Speculation An ongoing project at the University of Illinois follows the advice of market advisors and compares the results to simply selling at harvest. Thus far there is little evidence that market advisory services consistently beat the market for soybeans and cotton. At the very least, speculative activities should be recognized as such. 15 Risk Assumption Any risk that is not being transferred is implicitly being assumed (self-insurance). Savings Credit reserves Reductions in standard of living 16 8
How Do You or Your Producers Manage Risk? Diversification? Off-farm farm income? Farm business is an LLC? Crop insurance? Forward pricing? Irrigation? Integrated pest management? 17 Managing Risk is Costly... Explicit costs Insurance premiums Cost of pesticides Cost of irrigation equipment Implicit costs Producing a commodity that is less risky but also has lower expected returns. Off-farm f investments t that t may have lower expected returns but are uncorrelated with farm returns. 18 9
But not Managing Risk can be Devastating Wishful thinking is not a risk management strategy. 19 Recommendations Know your cost of production and your financial position. Conduct a risk inventory. Consider your tolerance for risk. Make informed risk management decisions. Risk reduction Risk transfer (talk to an insurance agent) Know how much risk you can absorb. 20 10