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Taking Charge of ManagingRisk on Your Farm

March 12, 2002

Moonraker Restaurant Marshall

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Let’s start by testing how you think Let’s start by testing how you think about risk:about risk:

Which would you prefer?Which would you prefer?

A. 80% chance you will win $4,000

20% chance you get $0

B. Win $3,200

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How about a downside choice:How about a downside choice:

Which would you prefer?Which would you prefer?

C. Lose $3,200

D. 80% chance you will lose $4,00020% chance you lose nothing.

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Summary:Summary:

A. 80% chance you will win $4,000; 20% Zero

B. Win $3,200

C. Lose $3,200

D. 80% chance you will lose $4,000; 20% Zero

Most people answer B and D

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• In the 1st “lottery,” the average was the same for both choices: + $3,200.

80% x $4,000 + 20% x $0 vs $3,200 for sure

• In the 2nd “lottery,” the average was the same for both choices: (- $3,200).

80% x (- $4,000) + 20% x $0 vs (- $3,200) for sure

• Most respondents were willing to give up upside potential. But, they kept downside risk.

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We tend to be inconsistent in our risk We tend to be inconsistent in our risk perceptions and choices:perceptions and choices:

• On one hand, many overreact to eye-catching, low probability events.

• On the other hand, we tend to ignore unlikely, low probability price and yield events when making plans. It won’t happen to me!

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Research SuggestsResearch Suggests::

• We tend to spend too much on more routine “hits” that, while unpleasant, can be coped with ...

• But we often don’t pay enough enough attention to protecting against big hit, low probability events.

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Summary:Summary:• How we “frame” information and choices tends

to keep us from making pricing and insurance choices that are as good as they can be.

• The consequences of these biases can be significant!

• Biases are normal. One focus of this workshop is designed to help you keep them from getting in the way of making good decisions.

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• Do you have written goals for your farming Do you have written goals for your farming

operation?operation?

• Are you meeting your Goals?Are you meeting your Goals?

Decision Making Environment

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Basic Goals Include...Basic Goals Include...

• Generating sufficient net income to support a comfortable “family income draw” from the farm business

• Ensure the financialsurvival and profitability of the farm business

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And, ...And, ...

• Have high level of satisfaction from the farm business

• See growth in farm business net worth

• Maintain financial ability to take advantage of business opportunities

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But, farms must contend with ...But, farms must contend with ...

• Ups and downs in the economic climate

• Lousy weather … that reduces yield, quality, or the ability to get in the field

• Changes in the USDA safety net

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• Let’s review some recent history

• Are there lessons that we can draw?

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Corn futures: the long viewCorn futures: the long view

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Reality Check IReality Check I

• Did the $5.00 spike in corn prices cloud your neighbors judgement in pricing 1998 corn? 1999? 2000? 2001?

• Did your neighbor “bet” on a drought in Iowa and Illinois in 1998? On drought in the western corn belt in 1999? On the “Drought of 2000”?

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What did the market say in What did the market say in March ‘98?March ‘98?

• 50-50 bet was CBOT harvest futures contract on corn at $2.70 / bu

• One chance in 3 of $2.50 or less

• One chance in 12 of $2.10 or less

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On the up side:On the up side:

• One chance in 3 of CBOT corn futures at harvest exceeding $2.90 /bu

• One chance in 5 of corn exceeding $3.10

• One chance in 12 of corn over $3.50

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Summary of the market’s estimate of price risk Summary of the market’s estimate of price risk exposure in early March ‘98exposure in early March ‘98

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1.70

1.90

2.10

2.30

2.50

2.70

2.90

3.10

3.30

3.50

3.70

Dec '98 Futures @ hvst

Ch

an

ces

ou

t o

f 10

0 p

rice

wil

l b

e l

ess

th

an

…

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What did the market do 1998?What did the market do 1998?

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Were There Lessons From 1999?Were There Lessons From 1999?

What About 2000 and 2001?What About 2000 and 2001?

2002 ?2002 ?

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Reality check IIReality check II

• Are yields more or less variable than annual average prices?

• Do farmers responses match what their records show?

• For most farms, yield risk exposure is real

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Chances of alternative corn yields: a review Chances of alternative corn yields: a review of the last 50 years for a Gratiot Co. Farmof the last 50 years for a Gratiot Co. Farm

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

10 28 46 64 82 100 118 136 154 172

Yield/planted acre

Ch

an

ces

in 1

00

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Reality check IIIReality check III

• On the average, over the last 27 years, there has been a 5¢ to 15¢ premium for pricing in the late spring-early summer weather market

• But, I don’t pre-harvest price because of yield risk, contract delivery exposure

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Check?Check?

• Is the yield risk exposure large enough to keep you from selective pre-harvest pricing?

• Are there other ways to get around yield risk exposure concerns?

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Changes...Changes...

• USDA no longer attempts to balance supply and demand with Acreage Reduction Programs

• Grain stock holding decisions are now in the private sector

• But, LDP’s may effect farmer’s timing of sales.

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How do prices respond to ending How do prices respond to ending stocks?stocks?

2

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

3

3.1

3.2

3.3

3.4

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Stocks-to-Use Ratio

De

c F

utu

res

$/b

u

95

97 9396

91

90

94

92

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Taking Charge of Taking Charge of Managing Your Risks:Managing Your Risks:

Goal = Increase Profitability and Ensure Financial Survival

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Today’s workshop will...Today’s workshop will...

• Help you identify and clarify how to manage your financial risk exposure

• Develop options that could improve your profitability and reduce the risk exposure in your operation

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Today’s workshop will...Today’s workshop will...• Help you structure your information on:– Your capacity to bear risk

– Revenues, required to cover:

• Cash flow requirements

• Maintain current level of equity

• Review the risk control tools that are available

• Use these “tools” in a “hand’s-on” case study – so you can use them on your farm

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END