Risk Management

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Risk Management
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Risk Management

• Outline
• Introduction
• Definition
• Sources of Risk
• Frequency, Magnitude, and rating risks
• Risk Tolerance
• Strategies for Managing Risk
• Payoff Matrix
• Risk Rules of Thumb

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Risk Management
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Risk Management

• Do You Take Unnecessary Risks????

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Risk Management
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Risk Management
Introduction
Identification and Management of the Sources of
Risk

Financial Success

Ignoring Risk Management
Financial Failure
(Often attributed to other Reasons)
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Risk Management
Introduction
Yield Projections
Typical Yield Estimate
Usually overestimated by 10 to 20
Based on historic yields - Last 7 to 12
years disregarding highs and lows and averaging
the rest
Realistic Yield Estimate

• Yield Projections are strongly influenced by
• Remembering past Good years while forgetting the
  Bad ones
• Optimism on good prices

Projections that are
Honest Realistic Representative Includes
Safety Factor
RISK MANAGEMENT
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Risk Management
Introduction
What is Risk Management?
Planning so that all your decisions produce a
positive impact on your profitability and
long-term growth.
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Risk Management
Definition
Risks Measurable possibility of losing or not
gaining value Probability of an unfavorable
outcome Possibility of events that can
jeopardize the fulfillment of GOALS Risk
Return Trade-off
Higher RISK Higher Returns Vice Versa
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Risk Management
Sources of Risk
MITIGATION
RISK
Difficult high-end products diversification,
rotat.
Production (weather, diseases)
Crop varieties, right chemicals.
Input performance
Forward contracts, crop insurance, hedging.
Commodity price
Forward contracts.
Input price
Difficult due to variability of interest rates.
Bank committed to agribusiness.
Borrowed capital price
Balance between early and late adoption.
Technology
Difficult on family (commitment) and external.
People
Liability insurance
Legal
Difficult. Agribusiness affected by gov.
decisions.
Institutional
Difficult. Anticipation to changes. Crystal ball?
Macroeconomic
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Risk Management
Frequency, Magnitude, and Rating Risks

• It may be estimated that once in a generation,
  every 25 to 35 years, there is a drought that
  cuts corn yields to 20 bu./acre

• Taking the drought yield, 20 bu./acre, and
  dividing it by the anticipated yield 125 bu./acre
  16 (drought year yield is 16 of expected
  harvest)

• Therefore, the drought caused a yield loss of 84
  (100 - 16)

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Risk Management
Frequency, Magnitude, and Rating Risks

• Now farmer has the data to make a decision like
  to buy yield insurance.
• Risk rating represent standard measures of risk
  which simplify the process of evaluating
  alternatives. Its a consistent, standardized
  system for considering trade-offs between risks
  and profits
• It is a MUST to develop expected outcomes of
  yields, costs, profits
• If you cant MEASURE it, you cant MANAGE it !!!!

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Risk Management
Frequency, Magnitude, and Rating Risks
Expected outcomes are not sufficient for
effective decision making
WHAT Ifs?

• Weather less favorable
• Prices lower than expected
• Less production due to genetic variability
• More insects than anticipated
• Change in government policies
• YOU NAME IT!!

Realized returns will not be equal to expected
revenues
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Risk Management
Frequency, Magnitude, and Rating Risks
There is always a chance that the outcome of a
decision will be less favorable than expected
when the decision was made Managers
responsibility to decide which Risks are MORE
critical PROBABILITIES Concept used in measuring
or quantifying chances 50/50 1 out of 2 or 0.5
or ½ 25 1 out of 4 or 0.25 or ¼
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Risk Management
Frequency, Magnitude, and Rating Risks
Probabilities
Averages and weighted averages
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Risk Management
Risk Tolerance

• There are as many degrees of risk tolerance as
  there are individuals
• Based on perception
• Different ways on how people respond to risk
  Risk averse, neutral or seeker
• The above is defined by a variety of factors
  specific to the individual, associated with
  potential gains and losses, managers financial
  position, goals and objectives, etc.

Risk Return Trade-off
Higher RISK Higher RETURNS and Vice Versa
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Risk Management
Risk Tolerance
Risk-bearing ability

• Measures whether the farm operation can withstand
  financial losses without going into liquidation
  or insolvency
• Risks affecting farm operation lead to Financial
  Risk (Which is also influenced by proportion of
  debt and equity)
• A Balance Sheet is used to measure the
  risk-bearing ability of a farm business. (It
  summarizes assets, liabilities and the equity of
  the business)
• Ratios used in analysis of risk bearing ability
  debt to asset, debt to equity, etc. (The lower
  these ratios, the higher risk-bearing ability of
  the business)

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Risk Management
Risk Tolerance
Evaluating the Financial Ability to take Risk

• Example with 3 farm situations
• They look pretty similar although difference lies
  in how the farm resources are controlled and
  financed
• The financial position of the farm depends on its
  net worth and the relationship between this net
  worth and the total debt outstanding

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Risk Management
Strategies for Managing Risk
Production / Financial

• Diversification

• Government programs

• Enterprise selection

• Farmers knowledge base and data base

• Insurance

• Farmers managerial expertise

• Resource reserves

• Availability of outside information

• Production management schemes
• (cash rent vs. share rent)

Financial and Personal

• Credit reserves and good liquidity

Marketing / Purchasing

• Pay out ag loans with ag income

• Several pricing strategies that help establish
  prices before delivery, such as
• sell cash, storage, forward cash contract,
  minimum price contract, basis contract,
• futures contract, price insurance through
  put options.

• They need to be revised on a yearly basis.

• Also for purchasing inputs, like forward
  purchases to lock-in price.

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Risk Management
Strategies for Managing Risk
Sensitivity Analysis

• Another approach to risk assessment
• Provides information about a range of possible
  outcomes
• Enables managers to determine which assumptions
  most strongly affect the forecast and which are
  secondary

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Risk Management
Strategies for Managing Risk
Sensitivity Analysis
Making all other variables constant
While making a change in a variable we wish to
examine
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Risk Management
Payoff Matrix
Technique used to help with decision-making
To build it , chart the decision choices against
possible events
We are concerned about the uncertainty of rainfall
We multiply each yield by the net selling crop
price 3 / bu.
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Risk Management
Payoff Matrix
Since we are interested in net payoffs, we
subtract fertilizer costs _at_ 0.2 per unit. 20
units x 0.2 4
Now, using probabilities, the expected payoff can
be calculated.
The expected payoffs are the average return the
farmer would expect from each decision
choice. (74 x 30)(116 x 50) (134 x 20)
107
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Risk Management
Risk Rules of Thumb
Risk Management is more than a method for
decision making
Risk Management includes evaluating objectives
and using common Sense

• What you want to do?
• What are reasonable alternatives to evaluate?
• Do the best you can to get it done

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Risk Management
Risk Rules of Thumb
Rule 1 There are no certain profits Profits
are a return to risk Objective is not to avoid
risk, but to manage it Rule 2 Higher profits
are generally associated with higher risks of
loss There are no slam dunk
investments Hidden risks maybe present
Normally, to obtain high profits, you must
risk higher losses Rule 3 There is no one
BEST STRATEGY All strategies are
different They vary with managers experience
and its goals Rule 4 Good strategies improve
the odds for success A well thought out plan
with good strategies cannot guarantee a good
outcome Good strategies will increase the odds
of favorable outcomes
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Risk Management
Risk Rules of Thumb
Rule 5 Decisions should be evaluated with
respect to objectives. To make a decision,
gather and compile all data to make it more
understandable, then, compare potential results
with your objectives Rule 6 Good decisions
sometimes have bad outcomes. Dont blame
yourself for a bad outcome. It will only distract
you from reviewing why it was a bad decision.
Learn from mistakes Rule 7 Good strategies,
over time, will produce good results. Be
patient with bad outcomes
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Risk Management
Quotations about Risk
If your life is ever going to get better, youll
have to take risks. There is simply no way you
can grow without taking chances. - David
Viscot.
Take risks if you win, you will be happy if
you lose, you will be wise. - Anon.
Courage is rarely reckless or foolish..courage
usually involves a highly realistic estimate of
the odds that must be faced. - Margaret Truman.
The only things you regret are the things that
you dont do. - Michael Curtiz.