15 Managing Risk Lesson

15 Managing Risk Lesson

The least we need to know.

Forward Contract

A situation whereby the selling price of a commodity is known before the farmer makes a decision to produce the crop.

Futures Market

A central location where forward contracts are bought and sold.

Five areas of risk in agricultural

Production & technical risk

Price & market risk

Financial risk

Legal risk

Personal risk

Coefficient of Variation, page 292

This measures variability relative to the mean and is found by dividing the standard deviation by the mean. Smaller coefficients of variation indicate that the distribution has less variability compared to its mean than other distributions

Safety First

this is a rule that concentrates on the worst possible outcome for each strategy and ignores the other possible outcomes. the decision maker assumes that the better-than-expected outcomes pose no serious problems, whereas the unfavorable outcomes are of real concern. Therefore, the strategy with the best possible result amoung the worst-case outcomes is selected, the one with the least bad value.

Tools for managing risk

Reduce variability of possible outcomes

Set a minimum income or price level (insurance)

Maintain flexibility of decision making

Fixed or Cash (Rent) Lease

A rental arrangement in which the operator

makes a cash payment to the owner for the use of certain

property, pays all production costs, and keeps all the

income generated.

Sensitivity analysis

A procedure for assessing the riskiness of a decision by using several possible price and/or production outcomes to budget the results, and then comparing them.

Share Leases

In many states, crop share leases and livestock share leases are common. the landown usually pays part of the operating expenses and receives a portion of the crops or livestock produced instead of a cash rental payment. They reduce the risk of poor production, low selling prices, or high input costs which are shared between tenant and the owner. The tenant also needs less operating capital vs. a cash lease. Some tenants use a variable cash lease to achieve similar risk reduction.

Custom Farming & Feeding

Custom farmers perform all field operations for a landowner in exchange for a fixed payment. The landowner takes all the price and yield risk. Custom feeding is similar whereby livestock producers feed animals owned by investors in their own facilities for fixed price per head or per space, or for a fixed rate per day.

Hedging

This involves selling a commodity futures contract instead of a the actual commodity, The contract is purchased by a buyer at a futures market exchange the purpose of which is to all a processor to lock in the price of the commodity. A manager should have a good understanding of basis , which is the normal difference beteen the futures contract price and the local cash market price. The variation is called basis risk and it should be taken into account. But, basis risk is less variable and more predictable than cash prices.

Commodity Options

A commodity option provides a type of price insurance.

A put option is a contract that gives the buyer the right to sell a futures contract for an agricultural commodity at a specified price.

The put option is used to set a minimum selling price in advance.

The call option is a contract that gives the buyer the right to buy a futures contract for an agricultural commodity at a specified price. The call option is used to set a maximum purchase price in advance.