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Managing Risk

Posted Dec. 1, 1997

Production agriculture is risky business. The process of assessing, understanding, and managing risk is complicated by the fact that risk is often, at least in part, in the eye of the beholder. Many producers routinely take big risks without truly coming to grip with the magnitude of their exposure. Perhaps this situation is a fault of past attempts at risk management education. The 'traditional model' of risk management has typically focused on production risk, financial risk, and marketing risk. Most emphasis has been placed on managing risk with insurance, contracts, and futures and options. Many have assumed that they will receive a higher price by employing 'risk management' strategies. Often, they experience a net lower price and become disillusioned with risk management.

A better model for managing risk and thus insuring survival into the 21st century, places emphasis on the value of the firm. In financial terms the current value of the firm is the discounted value of future cash flows. To manage risk in this context, producers must asses how their cash flow is affected by different risks. Taking positions that alter the riskiness of future cash flows can increase the firm's value. Risk management increases value by decreasing the probability of financial distress and by assuring that funds, either equity or debt, are available when profitable investment opportunities arise. To manage risk in this model, a producer must determine how his cash flow is affected by different risks. If feeder steers sell for $70 per hundred weight (cwt.) rather than $75 per cwt., how will the firm's cash flow be affected? The firm's cash flow exposure to a specific risk is a quantitative measure of how cash flow is related to that risk. Once risk exposures have been identified, strategies can be designed to modify the exposure and thus protect or 'insure' that cash flow will be sufficient to meet obligations and continue operations for another year.

If you desire help in assessing the risks inherent to your operation and developing short and long term strategies for coping with these risks, contact one of the consulting teams at the Noble Research Institute.

Thought for the Month: "The fellow that can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one that can see years ahead, he has a telescope but he can't make anybody believe that he has it." Will Rogers