RISK MANAGEMENTRISK MANAGEMENT

DIVERSIFICATIONDIVERSIFICATION MARKETING ALTERNATIVESMARKETING ALTERNATIVES FLEXIBILITYFLEXIBILITY CREDIT RESERVESCREDIT RESERVES INSURANCEINSURANCE

DIVERSIFICATIONDIVERSIFICATION

IT MAY BE POSSIBLE TO REDUCE IT MAY BE POSSIBLE TO REDUCE THE TOTAL VARIABILITY OF THE TOTAL VARIABILITY OF RETURNS BY COMBINING SEVERAL RETURNS BY COMBINING SEVERAL ASSETS, ENTERPRISES, OR INCOME-ASSETS, ENTERPRISES, OR INCOME-GENERATING ACTIVITIES WITHOUT GENERATING ACTIVITIES WITHOUT UNDULY SACRIFICING EXPECTED UNDULY SACRIFICING EXPECTED RETURNS.RETURNS.

HOLDING A COMBINATION OF HOLDING A COMBINATION OF INVESTMENTS IS CALLED INVESTMENTS IS CALLED DIVERSIFICATIONDIVERSIFICATION

A PORTFOLIO REFERS TO A MIX OR A PORTFOLIO REFERS TO A MIX OR COMBINATION OF ASSETS, COMBINATION OF ASSETS, ENTERPRISES, OR INVESTMENTSENTERPRISES, OR INVESTMENTS

LETS LOOK AT AN EXAMPLE LETS LOOK AT AN EXAMPLE OF DIVERSIFICATIONOF DIVERSIFICATION

AN INVESTOR IS EVALUATING TWO FARM AN INVESTOR IS EVALUATING TWO FARM UNITS, ONE LOCATED IN THE CORN BELT UNITS, ONE LOCATED IN THE CORN BELT AND THE OTHER LOCATED IN THE AND THE OTHER LOCATED IN THE GREAT PLAINS.GREAT PLAINS.

EACH FARM HAS AN EXPECTED RETURN EACH FARM HAS AN EXPECTED RETURN ON ASSETS OF 20% AND A STANDARD ON ASSETS OF 20% AND A STANDARD DEVIATION OF RETURNS OF 10%DEVIATION OF RETURNS OF 10%

THEREFORE, THE INVESTOR WOULD BE THEREFORE, THE INVESTOR WOULD BE INDIFFERENT BETWEEN THE TWO INDIFFERENT BETWEEN THE TWO FARMS.FARMS.

HOWEVER, SINCE THE TWO FARMS ARE HOWEVER, SINCE THE TWO FARMS ARE LOCATED IN DIFFERENT REGIONS AND LOCATED IN DIFFERENT REGIONS AND HAVE A DIFFERENT MIX OF HAVE A DIFFERENT MIX OF ENTERPRISES A COMBINATION OF ENTERPRISES A COMBINATION OF INVESTMENT IN THE TWO FARMS MIGHT INVESTMENT IN THE TWO FARMS MIGHT PROVIDE AN ADVANTAGE IN RISKPROVIDE AN ADVANTAGE IN RISK

THE PORTFOLIO THE PORTFOLIO MODELMODEL A PORTFOLIO'S EXPECTED RETURN A PORTFOLIO'S EXPECTED RETURN

IS THE WEIGHTED AVERAGE OF IS THE WEIGHTED AVERAGE OF THE INDIVIDUAL EXPECTED THE INDIVIDUAL EXPECTED RETURNS WEIGHTED BY THE RETURNS WEIGHTED BY THE PERCENT OF INVESTMENT IN EACHPERCENT OF INVESTMENT IN EACH

RRTT = r = r1 1 PP1 1 + r+ r2 2 PP11

A PORTFOLIO'S TOTAL VARIANCE IS A PORTFOLIO'S TOTAL VARIANCE IS THE SUM OF THE INDIVIDUAL THE SUM OF THE INDIVIDUAL PROPORTIONAL VARIANCES PLUS PROPORTIONAL VARIANCES PLUS (OR MINUS) THE COVARIANCE(OR MINUS) THE COVARIANCE

σσTT2 2 = = σσ11

22 PP1 1

2 2 + + σσ2222 PP2 2

22 + 2 + 2 PP1 1 PP2 2 c c σσ11σσ22

σσ11

WHERE:WHERE:RRTT IS THE PORTFOLIO EXPECTED RETURN IS THE PORTFOLIO EXPECTED RETURN

rri i IS THE EXPECTED RETURN FOR EACH IS THE EXPECTED RETURN FOR EACH INVESTMENTINVESTMENT

PPi i IS THE PROPORTION OF INVESTED IN EACH IS THE PROPORTION OF INVESTED IN EACH INVESTMENTINVESTMENT

σσTT2 2 IS THE PORTFOLIO VARIANCEIS THE PORTFOLIO VARIANCE

σσi i IS THE STANDARD DEVIATION FOR EACH IS THE STANDARD DEVIATION FOR EACH INVESTMENT INVESTMENT

c IS THE CORRELATION COEFFICIENT BETWEENc IS THE CORRELATION COEFFICIENT BETWEENRETURNS FOR EACH INVESTMENT.RETURNS FOR EACH INVESTMENT.

IF WE ASSUME THAT THE IF WE ASSUME THAT THE PROPORTION INVESTED IN EACH PROPORTION INVESTED IN EACH FARM IS 50% AND THE FARM IS 50% AND THE CORRELATION BETWEEN RETURNS CORRELATION BETWEEN RETURNS IS 0.5 WHAT WOULD BE THE IS 0.5 WHAT WOULD BE THE PORTFOLIO EXPECTED RETURN PORTFOLIO EXPECTED RETURN AND STANDARD DEVIATION?AND STANDARD DEVIATION?

THE EXPECTED PORTFOLIO RETURN THE EXPECTED PORTFOLIO RETURN WOULD BE:WOULD BE:

RRTT = (0.20)(0.5) = (0.20)(0.5) + (0.20)(0.5) = 0.20+ (0.20)(0.5) = 0.20

THE EXPECTED PORTFOLIO THE EXPECTED PORTFOLIO VARIANCE WOULD BE:VARIANCE WOULD BE:

σσTT2 2 = (0.10)= (0.10)22

(0.50)(0.50) 2 2 + (0.10)+ (0.10)22

(0.50)(0.50) 22 + +

2 (0.50) (0.50) (0.50) (0.10) (0.10)2 (0.50) (0.50) (0.50) (0.10) (0.10)

= (0.0025) + (0.0025) + (0.0025)= (0.0025) + (0.0025) + (0.0025)

= 0.0075= 0.0075

σσTT = 0.0866 or 8.66%= 0.0866 or 8.66%

THE KEY COMPONENT WITH REGARD THE KEY COMPONENT WITH REGARD TO CONSTRUCTING A PORTFOLIO TO CONSTRUCTING A PORTFOLIO THAT REDUCES RISK WHILE THAT REDUCES RISK WHILE MAINTAINING RETURN IS THE MAINTAINING RETURN IS THE CORRELATION COEFFICIENT CORRELATION COEFFICIENT BETWEEN RETURNS FOR THE BETWEEN RETURNS FOR THE INVESTMENTSINVESTMENTS

CORRELATION OF CORRELATION OF RETURNSRETURNS

THE VALUE OF THE CORRELATION THE VALUE OF THE CORRELATION COEFFICIENT BETWEEN THE COEFFICIENT BETWEEN THE RETURNS OF INVESTMENTS “c” CAN RETURNS OF INVESTMENTS “c” CAN TAKE ON A VALUE BETWEEN TAKE ON A VALUE BETWEEN

-1 -1 ≤ ≤ c c ≤ ≤ 1 1

PORTFOLIO VARIANCE FOR PORTFOLIO VARIANCE FOR DIFFERENT VALUES OF “c”DIFFERENT VALUES OF “c”

c = -1c = -1

σσTT2 2 = = σσ11

22 PP1 1

2 2 + + σσ2222 PP2 2

22 - 2 - 2 PP1 1 PP22σσ11σσ22

c = 0c = 0

σσTT2 2 = = σσ11

22 PP1 1

2 2 + + σσ2222 PP2 2

22

c = 1c = 1

σσTT2 2 = = σσ11

22 PP1 1

2 2 + + σσ2222 PP2 2

22 + 2 + 2 PP1 1 PP2 2 σσ11σσ22

USING THE PREVIOUS USING THE PREVIOUS EXAMPLEEXAMPLE

IF c = -1:IF c = -1:

σσTT2 2 = (0.10)= (0.10)22

(0.50)(0.50) 2 2 + (0.10)+ (0.10)22

(0.50)(0.50) 22 + +

2 (0.50) (0.50) (-1.0) (0.10) (0.10)2 (0.50) (0.50) (-1.0) (0.10) (0.10)

= (0.0025) + (0.0025) - (0.005)= (0.0025) + (0.0025) - (0.005)

= 0.0= 0.0

σσTT = 0.0%= 0.0%

USING THE PREVIOUS USING THE PREVIOUS EXAMPLEEXAMPLE

IF c = 0:IF c = 0:

σσTT2 2 = (0.10)= (0.10)22

(0.50)(0.50) 2 2 + (0.10)+ (0.10)22

(0.50)(0.50) 22 + +

2 (0.50) (0.50) (0.0) (0.10) (0.10)2 (0.50) (0.50) (0.0) (0.10) (0.10)

= (0.0025) + (0.0025) = (0.0025) + (0.0025)

= 0.005= 0.005

σσTT = 7.07%= 7.07%

USING THE PREVIOUS USING THE PREVIOUS EXAMPLEEXAMPLE

IF c = 1:IF c = 1:

σσTT2 2 = (0.10)= (0.10)22

(0.50)(0.50) 2 2 + (0.10)+ (0.10)22

(0.50)(0.50) 22 + +

2 (0.50) (0.50) (1.0) (0.10) (0.10)2 (0.50) (0.50) (1.0) (0.10) (0.10)

= (0.0025) + (0.0025) + 0.005 = (0.0025) + (0.0025) + 0.005

= 0.01= 0.01

σσTT = 10.00%= 10.00%

Risk

Profits

A B

C

D

E F

G H

RISK – RETURN TRADE 0FFRISK – RETURN TRADE 0FF

WHAT IS TERMED A RISK EFFICIENT WHAT IS TERMED A RISK EFFICIENT SET OF PORTFOLIOS IS COMPOSED SET OF PORTFOLIOS IS COMPOSED OF PORTFOLIOS OF ASSETS THAT OF PORTFOLIOS OF ASSETS THAT MINIMIZE VARIANCE FOR MINIMIZE VARIANCE FOR DIFFERENT LEVELS OF EXPECTED DIFFERENT LEVELS OF EXPECTED RETURNSRETURNS

THE PORTFOLIOS IN THE THE PORTFOLIOS IN THE PRECEDING GRAPH OF THE RISK-PRECEDING GRAPH OF THE RISK-RETURN TRADE OFF ILLUSTRATES RETURN TRADE OFF ILLUSTRATES THE CONCEPT OF RISK EFFICIENCYTHE CONCEPT OF RISK EFFICIENCY

PORTFOLIO “A” DOMINATES PORTFOLIO “A” DOMINATES PORTFOLIO “C” FOR RETURN AND PORTFOLIO “C” FOR RETURN AND PORTFOLIO “B” FOR RISKPORTFOLIO “B” FOR RISK

PORTFOLIOS “A” “D” “G” AND “H” PORTFOLIOS “A” “D” “G” AND “H” REPRESENT PORTFOLIOS THAT LIE REPRESENT PORTFOLIOS THAT LIE ON THE RISK EFFICIENT FRONTIER ON THE RISK EFFICIENT FRONTIER WHICH GIVES THE HIGHEST WHICH GIVES THE HIGHEST RETURN FOR A GIVEN LEVEL OF RETURN FOR A GIVEN LEVEL OF RISKRISK

ENTERPRISE ENTERPRISE DIVERSIFICATION IN DIVERSIFICATION IN AGRICULTUREAGRICULTURE

DIVERSIFYING AMONG SEVERAL DIVERSIFYING AMONG SEVERAL FARM ENTERPRISES AND EVEN FARM ENTERPRISES AND EVEN BETWEEN FARM AND NON-FARM BETWEEN FARM AND NON-FARM ACTIVITIES IS A TRADITIONAL ACTIVITIES IS A TRADITIONAL APPROACH TO RISK MANAGEMENT APPROACH TO RISK MANAGEMENT IN AGRICULTUREIN AGRICULTURE

THIS TYPE OF DIVERSIFICATION IS THIS TYPE OF DIVERSIFICATION IS BASED ON THE PREMISE THAT BASED ON THE PREMISE THAT THERE IS A LOW OR NEGATIVE THERE IS A LOW OR NEGATIVE CORRELATION OF RETURNS CORRELATION OF RETURNS AMONG SOME ENTERPRISES THAT AMONG SOME ENTERPRISES THAT WILL STABILIZE TOTAL RETURNS WILL STABILIZE TOTAL RETURNS OVER TIME.OVER TIME.

A CONSIDERATION WITH A CONSIDERATION WITH ENTERPRISE DIVERSIFICATION IS ENTERPRISE DIVERSIFICATION IS THE THE LOSS OF EFFICIENCIES AND LOSS OF EFFICIENCIES AND RETURNS THAT MAY BE DERIVED RETURNS THAT MAY BE DERIVED FROM SPECIALIZATIONFROM SPECIALIZATION..

MARKETING MARKETING ALTERNATIVESALTERNATIVES

THE USE OF HEDGING, OPTIONS, AND THE USE OF HEDGING, OPTIONS, AND FORWARD CONTRACTING ARE TOOLS FORWARD CONTRACTING ARE TOOLS THAT CAN BE USED TO MANAGE RISK THAT CAN BE USED TO MANAGE RISK FOR BOTH OUTPUT PRICES AND INPUT FOR BOTH OUTPUT PRICES AND INPUT PRICES.PRICES.

MARKETING POOLS, SUCH AS THE PCCA MARKETING POOLS, SUCH AS THE PCCA COTTON MARKETING POOL, CAN ALSO COTTON MARKETING POOL, CAN ALSO PROVIDE A USEFUL MARKETING PROVIDE A USEFUL MARKETING ALTERNATIVE.ALTERNATIVE.

FLEXIBILITYFLEXIBILITY

FLEXIBILITY IN A BUSINESS FLEXIBILITY IN A BUSINESS ORGANIZATION ENABLES THE ORGANIZATION ENABLES THE MANAGER TO RESPOND MORE MANAGER TO RESPOND MORE QUICKLY AS NEW INFORMATION QUICKLY AS NEW INFORMATION BECOMES AVAILABLE TO THE BECOMES AVAILABLE TO THE FIRM.FIRM.

FLEXIBILITY DOES NOT DIRECTLY REDUCE FLEXIBILITY DOES NOT DIRECTLY REDUCE RISK, BUT PROVIDES A MEANS OF RISK, BUT PROVIDES A MEANS OF COPING WITH RISKCOPING WITH RISK..

EXAMPLES OF FLEXIBILITY ARE:EXAMPLES OF FLEXIBILITY ARE: REDUCING FIXED COSTS RELATIVE TO REDUCING FIXED COSTS RELATIVE TO

VARIABLE COSTS.VARIABLE COSTS. CHOOSING NONSPECIFIC RESOURCES IN CHOOSING NONSPECIFIC RESOURCES IN

PLACE OF SPECIFIC RESOURCES.PLACE OF SPECIFIC RESOURCES. MANAGERS THAT ARE WILLING TO MANAGERS THAT ARE WILLING TO

MAKE CHANGES WHEN NEEDED OR AS MAKE CHANGES WHEN NEEDED OR AS CONDITIONS WARRANTCONDITIONS WARRANT

FLEXIBILITY HAS SOME OF THE FLEXIBILITY HAS SOME OF THE SAME PROBLEMS AS WITH SAME PROBLEMS AS WITH DIVERSIFICATION IN THAT BEING DIVERSIFICATION IN THAT BEING FLEXIBLE MAY ENTAIL LESS FLEXIBLE MAY ENTAIL LESS SPECIALIZATION AND THE GAINS SPECIALIZATION AND THE GAINS IN EFFICIENCIES.IN EFFICIENCIES.

CREDIT RESERVESCREDIT RESERVES

A CREDIT RESERVE IS A SOURCE OF A CREDIT RESERVE IS A SOURCE OF LIQUIDITY.LIQUIDITY.

A FIRM’S CREDIT RESERVE IS A FIRM’S CREDIT RESERVE IS REPRESENTED BY ITS UNUSED REPRESENTED BY ITS UNUSED BORROWING CAPACITY.BORROWING CAPACITY.

THE DIFFERENCE BETWEEN THE THE DIFFERENCE BETWEEN THE MAXIMUM AMOUNT OF POTENTIAL MAXIMUM AMOUNT OF POTENTIAL BORROWING AND THE AMOUNT BORROWING AND THE AMOUNT ALREADY BORROWED IS THE CREDIT ALREADY BORROWED IS THE CREDIT RESERVE.RESERVE.

IN GENERAL, CREDIT IS IN GENERAL, CREDIT IS CONSIDERED A HIGHLY EFFICIENT CONSIDERED A HIGHLY EFFICIENT WAY TO PROVIDE LIQUIDITY.WAY TO PROVIDE LIQUIDITY.

USING CREDIT DOES NOT DISTURB USING CREDIT DOES NOT DISTURB A FIRM’S BASIC ASSET A FIRM’S BASIC ASSET STRUCTURE AND PRODUCTION STRUCTURE AND PRODUCTION ORGANIZATION.ORGANIZATION.

TRANSACTIONS COSTS OF CREDIT TRANSACTIONS COSTS OF CREDIT ARE RELATIVELY LOW.ARE RELATIVELY LOW.

CREDIT IS GENERALLY AVAILABLE.CREDIT IS GENERALLY AVAILABLE.

INSURANCEINSURANCE

INSURANCE PROVIDES A SPECIALIZED INSURANCE PROVIDES A SPECIALIZED FORM OF LIQUIDITY, INSTEAD OF FORM OF LIQUIDITY, INSTEAD OF RESERVING CASH, SAVINGS OR CREDIT RESERVING CASH, SAVINGS OR CREDIT TO COUNTER LOSSES DUE TO EVENTS TO COUNTER LOSSES DUE TO EVENTS SUCH AS HAIL OR CAUSALITY LOSSSUCH AS HAIL OR CAUSALITY LOSS

INSURANCE PROTECTS AN ASSET OR INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED EVENTS.OCCURRENCE OF SPECIFIED EVENTS.

INSURANCE PROTECTS AN ASSET INSURANCE PROTECTS AN ASSET OR FLOW OF INCOME AGAINST THE OR FLOW OF INCOME AGAINST THE OCCURRENCE OF SPECIFIED OCCURRENCE OF SPECIFIED EVENTS.EVENTS.