Literature Review of Managing Risk in Farming Concepts Finance Essay

Joy Harwood, Richard Heifner, Keith Coble, Janet Perry, and Agapi Somwaru (1999), "Managing Risk in Farming: Concepts, Research, and Analysis", Agricultural Economic Report No. 774. Washington DC, Economic Research Service, U.S. Department of Agriculture.

Risk and Risk Management

Risk is the possibility of adversity or loss (Bodie and Merton) and refers to "uncertainty that matters." Consequently, risk management involves choosing among alternatives to reduce the effects of risk. Risk management typically requires the evaluation of tradeoffs between changes in risk, expected returns, entrepreneurial freedom, and other variables. Understanding risk is a starting point to help producers make good management choices in situations where adversity and loss are possibilities. Some risk management strategies (such as diversification) reduce risk with-in the farm's operation, others(such as production contracting) transfer risk outside the farm, and still others (such as maintaining liquid assets) build the farm's capacity to bear risk.

Sources of Risk in Farming

Some risks are unique to agriculture, such as the risk of bad weather significantly reducing yields within a given year. Other risks, such as the price or institutional risks discussed below, while common to all businesses, reflect an added economic cost to the producer. If the farmer's benefit-cost tradeoff favors mitigation, then he will attempt to lower the possibility of adverse effects. These risks include the following: (Hardaker, Huirne, and Anderson; Boehlje and Trede;Baquet, Hambleton, and Jose; Fleisher)

Production or yield risk

Yield risk occurs because agriculture is affected by many uncontrollable events that are often related to weather, including excessive or insufficient rainfall, extreme temperatures, hail, insects, and diseases. Technology plays a key role in production risk in farming. The rapid introduction of new crop varieties and production techniques often offers the potential for improved efficiency, but may at times yield poor results, particularly in the short term. In contrast, the threat of obsolescence exists with certain practices (for example, using machinery for which parts are no longer available), which creates another kind of risk.

Price or market risk

Price or market risk reflects risks associated with changes in the price of output or of inputs that may occur after the commitment to production has begun. In agriculture, production generally is a lengthy process. Livestock production, for example, typically requires ongoing investments in feed and equipment that may not produce returns for several months or years. Because markets are generally complex and involve both domestic and international considerations, producer returns may be dramatically affected by events in far-removed regions of the world.

Institutional risk

Institutional risk results from changes in policies and regulations that affect agriculture. This type of risk is generally manifested as unanticipated production constraints or price changes for inputs or for output. For example, changes in government rules regarding the use of pesticides (for crops) or drugs (for livestock) may alter the cost of production or a foreign country's decision to limit imports of a certain crop may reduce that crop's price. Other institutional risks may arise from changes in policies affecting the disposal of animal manure, restrictions in conservation practices or land use, or changes in income tax policy or credit policy.

Human or Personal Risks

Farmers are also subject to the human or personal risks that are common to all business operators. Disruptive changes may result from such events as death, divorce, injury, or the poor health of a principal in the firm. In addition, the changing objectives of individuals involved in the farming enterprise may have significant effects on the long run performance of the operation. Asset risk is also common to all businesses and involves theft, fire, or other loss or damage to equipment, buildings, and livestock. A type of risk that appears to be of growing importance is contracting risk, which involves opportunistic behavior and the reliability of contracting partners.

Financial risks

Financial risk differs from the business risks previously described in that it results from the way the firm's capital is obtained and financed. A farmer may be subject to fluctuations in interest rates on borrowed capital, or face cash flow difficulties if there are insufficient funds to repay creditors. The use of borrowed funds means that a share of the returns from the business must be allocated to meeting debt payments. Even when a farm is 100-percent owner financed, the opera-tor's capital is still exposed to the probability of losing equity or net worth.

How Farmers Can Manage Risk

Farmers have many options in managing agricultural risks. They can adjust the enterprise mix (diversify) or the financial structure of the farm (the mix of debt and equity capital). In addition, farmers have access to various tools-such as insurance and hedging-that can help reduce their farm-level risks. Indeed, most producers combine the use of many different strategies and tools. Producers must decide on the scale of the operation, the degree of control over resources (including how much to borrow and the number of hours, if any, worked off the farm), the allocation of resources among enterprises, and how much to insure and price forward.

Enterprise Diversification

Diversification is a frequently used risk management strategy that involves participating in more than one activity. The motivation for diversifying is based on the idea that returns from various enterprises do not move up and down in lockstep, so that when one activity has low returns, other activities likely would have higher returns. A crop farm, for example, may have several productive enterprises (several different crops or both crops and livestock), or may operate disjoint parcels so that localized weather disasters are less likely to yields risk for all crops simultaneously.

Vertical Integration

Vertical integration includes all of the ways that output from one stage of production and distribution is transferred to another stage. Farming has traditionally operated in an open production system, where a commodity is purchased from a producer at a market price determined at the time of purchase. The use of open production has declined and vertical coordination has increased as consumers have become increasingly sophisticated and improvements in technology have allowed greater product differentiation (Martinez and Reed).

In practice, vertical integration in agriculture often involves owner-ship of both farm production and processing activities; like sorting, assembling, and packaging products for retail sales. While the above examples relate to individual operations, farmers may join together in a cooperative organization that is vertically integrated across functions.

Production contracts

Production contracts typically give the contractor (the buyer of the commodity) considerable control over the production process (Perry, 1997). These contracts usually specify in detail the production inputs supplied by the contractor, the quality and quantity of a particular commodity that is to be delivered, and the compensation that is to be paid to the grower. Firms commonly enter into production contracts with farmers to ensure timeliness and quality of commodity deliveries, and to gain control over the methods used in the production process. Production contracting is particularly favored when specialized inputs and complex production technologies are used, and the end product must meet rigid quality levels and possess uniform characteristics. Production contracting is also favored when oversupply and undersupply have been problems, the risk-return tradeoffs are advantageous to both the producer and the contracting firm, production technologies are specific, uniform, and knowledge-based, centralized management is feasible, and the commodity is highly perishable (Kliebenstein and Lawrence; Harris).

Evidence suggests that farmers enter production contracts to guarantee market access, improve efficiency, and ensure access to capital. Most production contracts lower farmers' price risks when compared with risks on the open market. This suggests that farmers are well aware of the risk-shifting capacity (Perry, 1997).

Marketing contracts

Marketing contracts are either verbal or written agreements between a buyer and a producer that set a price and/or an outlet for a commodity before harvest or before the commodity is ready to be marketed (Perry, 1997). The contract terms vary across contracts, but typically establish a price (or contain provisions for setting a price at a later date) and provide for delivery of a given quality (or grade) within a specified time period at a "flat price" (or fixed price). In contrast, minimum-price contracts guarantee the producer a minimum price for harvest delivery, based on futures price quotes at the time the contract is established, with the incorporation of a pricing formula that gives farmers the opportunity to sell at a higher price if futures prices increase before the contract expires. Most types of contracts do not completely eliminate price risk except the flat-price contracts, which establish an exact price to be paid to the grower upon delivery and thus completely eliminate price risk.

Liquidity

Another aspect of financial risk management is liquidity, which involves the farmer's ability to generate cash quickly and efficiently in order to meet his financial obligations (Barry and Baker). The liquidity issue relates to cash flow and addresses the question: "When adverse events occur, does a farmer have assets (or other monetary sources) that can easily be converted to cash to meet his financial demands?" Examples of liquid assets include grain in storage, cash, and company stock holdings, while illiquid assets include land, machinery, and other fixed assets.

Leasing Inputs and Hiring Custom Work

Producers can also manage their farming risks by either leasing inputs (including land) or hiring workers during harvest or other peak months. Leasing refers to a capital transfer agreement that provides the renter (the actual operator) with control over assets owned by someone else for a given period, using a mutually agreed-upon rental arrangement (Perry, 1997).

Farmers can lease land, machinery, equipment, or livestock. Leasing reduces the long-term fixed payments on borrowed capital that may strain liquidity in years of reduced output, and can reduce both financial and production risk for the renter (Sommer and others, 1998).

Crop Insurance

Insurance is often used by crop producers to mitigate yield (and hence, revenue) risk, and is obviously prevalent outside of agriculture. Property, health, automobile, and liability insurance are all forms of insurance regularly purchased by individuals to mitigate risk. For an individual, the use of insurance involves the exchange of a fixed, relatively small payment (the premium) for protection from uncertain, but potentially large, losses (Ray).

The Government should also reinsures private companies that sell policies (that is, the Government shares in the risk of loss) to help reduce financial losses in years of widespread disasters. Risk protection is greatest when crop-yield insurance (which provides yield risk protection) is combined with forward pricing or hedging (which provide price risk protection).

Off-farm Employment and Off-farm Income

Earning off-farm income is another strategy that farmers may use to mitigate the effects of agricultural risk on farm family household income. Farm household income can be categorized as earned off-farm income (wages and salaries), unearned off-farm income (social security, pensions, and investments), and farm net cash income. Off-farm income not only can supplement household income, it may also provide a more reliable stream of income than farm returns. In essence, off-farm income can offer a form of diversification to counter negative fluctuations in farm income. Farm household total income has been found significantly less variable if producers and their spouses worked off the farm (Mishra and Goodwin, 1997).

Other Ways of Managing Risk

Many other diverse strategies for farm risk management are commonly used by producers on their operations. Some of these additional strategies include the following:

Adjusting inputs and outputs (Improve Technical and Allocative Efficiency)

Producers can respond to risk by altering output levels, input use, or some combination of the two. Research indicates that greater output price risk results in lower levels of both input use and final output. Given that preferences toward risk and circumstances can vary greatly across producers, the final input and output levels chosen by producers can, accordingly, vary considerably for individuals in similar situations.

Cultural Practices or Indigenous Knowledge

Cultural practices can be used to enhance yield and, hence, reduce income risk. One such practice involves planting short-season varieties that mature earlier in the season, protecting against the risk of early frost and yield loss. Supplemental irrigation due to abnormal weather is another means to protect against yield loss.

Excess Machine Capacity

A farmer may have enough machine capacity so that planting and harvesting crops can occur more rapidly than needed under normal weather conditions. By having such resources, the farmer can avoid delays at either planting or harvest that may reduce yield losses.

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