Agricultural Economics

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Agricultural Economics Rural Sociology

• Ag. Econ. 417

Risk Management in Agriculture (Section 01 and
51) Day 2 Feb 19
Larry Makus [phone] lmakus_at_uidaho.edu http
//courses.ag.uidaho.edu/aers/agecon417/
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Ag. Risk Management Announcements

• Handout on website entitled
• Managing Risk in Farming
• read Appendix 1 and Appendix 2 (pages
  107-122).
• Quiz Thurs. over Lectures 1 and 2
• two readings for today.

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Ag. Risk Management Lecture Outline

• A. Decision-making procedure that incorporates
  risk.
• B. Risk Management Tools Discussion
• - from class
• C. Additional risk management tools
• - follow-up on readings.
• D. Risk-quiz and analysis
• - just for fun!
• E. Measuring risk
• - probability basics.
• - applied to ag. risk
• evaluation.

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Ag. Risk Management Decision-Making Process

• A. Management decision-making steps recognizing
  risk
• 1. Setting goals and objectives
• - balance between profit and risk.
• 2. Identify the problem
• - what decision needs to be made?
• 3. Determine alternatives
• - what risk mngt. tools are
  available?

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Ag. Risk Management Decision-Making Process

• A. Management decision-making steps recognizing
  risk (cont.)
• 4. Evaluate the alternatives
• - choose the best alternative.
• 5. Take responsibility for the outcome
• - good bad outcomes.

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Ag. Risk Management Risk Management Tools

• 1. Production risk
• - Ideas (think about both categories)?

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Ag. Risk Management Risk Management Tools

• 2. Marketing (Price) risk
• - Ideas (both categories??)

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Ag. Risk Management Risk Management Tools

• 3. Financial risk
• - Ideas?

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Ag. Risk Management Risk Management Tools

• 4. Legal risk
• - Ideas?

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Ag. Risk Management Risk Management Tools

• 5. Human resource risk
• - Ideas?

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Ag. Risk Management Risk Management Tools

• 6. Government policy risk
• - Ideas?

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Ag. Risk Management Risk Management Tools

• 1. Production risk
• a. Diversification
• - select low risk alternatives
• - combining enterprises
• - geographically
• b. Management practices
• - preventative practices.
• c. Crop insurance
• - hail, fire, etc.
• - MPCI (Multi-Peril Crop Insurance)
• d. Contracting

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Ag. Risk Management Risk Management Tools

• 2. Market (Price) risk
• a. Innovative marketing tools
• - cash forward contracts
• - hedging (future and options)
• - storage
• - spreading sales
• b. Direct sales.
• c. Cooperatives.
• d. Insurance products.

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Ag. Risk Management Risk Management Tools

• 3. Financial risk
• a. Financial analysis
• - good financial records.
• b. Judicious use of credit.
• c. Financial reserves.
• d. Off-farm income.
• e. Lease versus buy
• - more flexibility?
• f. Insurance.

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Ag. Risk Management Risk Management Tools

• 4. Legal risk
• a. Appropriate legal structure.
• b. Seek legal advice.
• c. Knowledge about potential liabilities.
• d. Insurance.

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Ag. Risk Management Risk Management Tools

• 5. Human resource risk
• a. Employee management
• - job descriptions
• - performance appraisal
• b. Managerial protection
• - insurance

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Ag. Risk Management Risk Management Tools

• B. Personal risk quiz
• a. General rules
• - write down you answers to each question.
• - dont over analyze, but react.
• - we will talk about your answers.

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Ag. Risk Management Risk Management Tools

• 1. Your on the way to a ballgame with someone
  and have a pair of tickets that cost 30.00.
  Park your car and realize you have lost the
  tickets. Are still seats available for 15.00
  each. Would you buy the tickets?
• a. buy tickets
• b. dont buy tickets

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Ag. Risk Management Risk Management Tools

• 2. Your on the way to a ballgame where you plan
  to buy two 15 tickets. Park your car and
  realize you have lost 30.00 when you paid for
  parking, but still have enough money to buy the
  two tickets. Would you buy the tickets?
• a. buy tickets
• b. dont buy tickets

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Ag. Risk Management Risk Management Tools

• 3. You have a choice between two options. The
  first is a sure gain of 700.00. The second
  offers a 75 percent chance of winning 1000 and a
  25 percent chance of winning nothing. Select an
  option
• a. a sure gain of 700
• b. a chance to win 1000

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Ag. Risk Management Risk Management Tools

• 4. You have a choice between two options. The
  first is a sure loss of 700.00. The second
  offers a 75 percent chance of losing 1000 and a
  25 percent chance of losing nothing. Select an
  option
• a. a sure loss of 700
• b. a 75 chance of a 1000 loss or
  a 25 chance at no loss

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Ag. Risk Management Risk Management Tools

• 5. The US is facing an outbreak of a rare avian
  flu that may kill 600 people. Two options are
  available to deal with the crisis. The first
  option has an expected death loss of 375 people.
  The second option has a 1/3 chance that no one
  will die and a 2/3 chance that 600 people will
  die. Select a program?
• a. a sure loss of 375
• b. 1/3 chance of no loss
  and 2/3 chance of 600 deaths

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Ag. Risk Management Risk Management Tools

• 6. Your are offered a choice between a sure cash
  prize versus a 50 chance of winning 100 and a
  50 chance of winning nothing. How large does
  the sure cash prize have to be to make the two
  alternatives equally attractive?
• a. 30 e. 50
• b. 35 f. 55
• c. 40 g. 60
• d. 45 h. 65

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Ag. Risk Management Risk Management Tools

• 7. Consider a situation where you face a 50
  percent chance of losing 100 and a 50 percent
  chance of winning a cash prize. What is the
  smallest cash prize that would make this risk
  acceptable to you?
• a. 50 e. 150
• b. 75 f. 175
• c. 100 g. gt200
• d. 125

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Ag. Risk Management Risk Management Tools

• 8. How many lottery tickets do you buy each
  month, on average?
• a. none
• b. one
• c. two
• d. three or more

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Ag. Risk Management Risk Management Tools

• 9. You are about to purchase a pair of shoes for
  40.00 and the salesperson tells you the same
  shoes are on clearance at their other store for
  20.00. It will take you about 20 minutes to get
  to the other store. Would you go to the other
  store?
• a. yes
• b. no

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Ag. Risk Management Risk Management Tools

• 10. You find a new car that you really like for
  19,500, but it does not have a CD player. The
  dealer will install a CD player, but the price
  goes to 19,860. You know you can purchase a
  comparable CD player at a stereo shop for 300,
  but this will take an extra hour.
  What would you do?
• a. buy w/CD for 19,860
• b. go to the stereo shop

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Ag. Risk Management Risk Management Tools

• 11. Paul has an investment in money market funds,
  and could have earned 25,000 more if the money
  had been invested in a stock fund over the last
  year. Mary had an investment in a stock fund,
  but sold her shares and switched to a money
  market fund last year. Her investment would have
  earned an additional 25,000 if left in the stock
  fund. Who feels worse?
• a. Paul
• b. Mary

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Ag. Risk Management Risk Management Tools

• Questions 1 and 2
• Typical (1) no (b) and (2) yes (a).
• Quantify cost
• are the same.

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Ag. Risk Management Risk Management Tools

• Question 3
• Typical a
• Highest expected outcome?
• b .75(1,000) .25(0) 750

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Ag. Risk Management Risk Management Tools

• Question 4
• Typical b
• lowest expected loss?
• a 700
• b .75(1000) .25(0) 750
• Losses treated different than gains?

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Ag. Risk Management Risk Management Tools

• Question 5
• Typical b
• lowest expected loss?
• a 375
• b .67(600) .33(0) 402
• Losses treated different than gains?
• Moral judgment?

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Ag. Risk Management Risk Management Tools

• Question 6
• Typical a,b,c, or d (risk averse)
• Expected payout .50 (100) 50
• Give up over 50, are risk loving and willing to
  pay for chance to win 50.

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Ag. Risk Management Risk Management Tools

• Question 7
• Typical d or above (risk averse)
• Even bet 100
• Losses treated different than gains?

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Ag. Risk Management Risk Management Tools

• Question 8
• Lottery tickets are a form of taxation and are
  notoriously bad bets.
• Any purchase suggests risk loving
• small purchase?
• entertainment value?
• donating to a good cause?

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Ag. Risk Management Risk Management Tools

• Questions 9 and 10
• Typical (9) is a. and (10) is a.
• Time value from Q9 60/hour
• Time value from Q10 60/hour

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Ag. Risk Management Risk Management Tools

• Question 11
• Typical Mary.
• Loss is the same.
• Loss from inaction rather than loss from a
  decision?
• Not selling wheat at 3.50
• price drops to 3.00.
• Selling for 3.00
• price rises to 3.50.

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Ag. Risk Management Intro to Probability

• A. Probability defined
• - a way of measuring the chance a particular
  event will occur.
• - 1 in 5, 20 percent, 1/5, 0.20
• B. Measuring probability
• 1. Chance of heads when you flip a fair
  coin?
• ½ or 0.50
• 2. Chance of rolling a 1
  with a six-sided die?
• 1/6 or 0.1667

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Ag. Risk Management Intro to Probability

• B. Measuring probability (cont.)
• 3. Chance of two heads in a row when
  flipping a fair coin?
• - HH,TH,HT,TT ¼
• 4. Chance of rolling a 7 with two six- sided
  dice?
• - 36 total outcomes

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Ag. Risk Management Intro to Probability

• 6 7 8 9 10 11 12
• d 5 6 7 8 9 10 11
• i 4 5 6 7 8 9 10
• e 3 4 5 6 7 8 9
• 2 3 4 5 6 7 8
• 1 1 2 3 4 5 6 7
• 1 2 3 4 5 6
• Die 2
• - chance for 7
  6/36 or 1/6

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Ag. Risk Management Intro to Probability

• B. Measuring probability (cont.)
• 5. How about chance of wheat price being
  above 4.00 per bushel next fall?
• - use historical data to measure probabilities?

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Figure 1. Distribution of Portland Wheat Prices
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Figure 2. Cumulative Probability Distribution
of Portland Wheat Prices
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Ag. Risk Management Intro to Probability

• B. Measuring probability (cont.)
• 6. How to quantify
• 1. For known events (dice), fairly easy.
• 2. For unknown events, not so easy
• - estimate from historical data.
• - personal experience.
• - expert opinion.

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Ag. Risk Management Intro to Probability

• C. Measuring expected value
• 1. Can measure if assign value to
  probability of events.
• 2. What is the expected value of a raffle
  ticket where 10,000 tickets are sold and the
  prize is 25,000?
• 0 x 0.9999 0
• 25,000 x 0.0001 2.50
• EV 2.50

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Ag. Risk Management Intro to Probability

• C. Measuring expected value (cont.)
• 2. What is the expected value of an
  enterprise (wheat) that has the following
  attributes
• 1 in 6 years return 100.00 per acre.
• 4 in 6 years return 60.00 per acre.
• 1 in 6 years return -25.00 per acre.
• 0.167 x 100 16.70
• 0.667 x 60 40.20
• 0.167 x 25 - 4.18
• EV 52.72/acre

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Ag. Risk Management Intro to Probability

• C. Measuring expected value (cont.)
• 3. What is the expected value of an
  enterprise (mustard) that has the following
  attributes
• 1 in 6 years return 500.00 per acre.
• 4 in 6 years return 20.00 per acre.
• 1 in 6 years return -200.00 per acre.
• 0.167 x 500 83.50
• 0.667 x 20 13.34
• 0.167 x -200 -33.40
• EV 63.44/acre

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Ag. Risk Management Intro to Probability

• C. Measuring expected value (cont.)
• 4. Which enterprise would you select and
  why?
• - what are we missing by looking only at
  expected value?
• Variability of returns!

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Ag. Risk Management Intro to Probability

• D. Measuring variability
• 1. Range
• - high and low values combined with
• expected value.
• 2. Standard deviation
• ? (xi x)2/n-11/2
• 3. Coefficient of variation
• - SD/mean
• - becomes a relative
  measure