Lecture 19 Risk and Uncertainty
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The document discusses the concepts of risk and uncertainty in agriculture, defining risk as a measurable situation with known outcomes and uncertainty as one with unknown outcomes. It outlines various sources of risks such as production, human, market, institutional, financial, and business risks, along with risk management strategies including mitigation, transfer, and coping. It emphasizes the importance of managing risks to maximize opportunities and outlines methods for measurement and reduction of risks in farming.
Lecture 19 Risk and Uncertainty
- 1. Lecture 19 : Risk and Uncertainty
- 2. Risks and Uncertainty: Definition • Risk is a situation of perfect knowledge where all possible outcomes are known for a given management decision and the probability associated with each possible outcome is also known. • Risk is measurable thereby insurable. • Uncertainty refers to those situations of imperfect knowledge that exist when: (i) all possible outcomes are unknown; (ii) the probability of the outcomes is unknown; and (iii) both outcomes and the probabilities are unknown. • Uncertainty cannot be measured thereby cannot be insured. • Risks are measured through probability concepts. 2
- 3. Examples for risk and uncertainty: 3 Particular Risk Uncertainty Knowledge Perfect knowledge Imperfect knowledge Outcome Known Not known Probability Known Not known Measurement Measurable Not measurable Insurance Insurable Not insurable Example Incidence of pest and diseases (negative) Shortfall in rainfall (negative) Fixed capital investments (positive) Monsoon failure / drought (negative) Implications of Chinese Corona Virus (COVID- 19) pandemic Outbreak of Avian flu Technology uncertainty
- 4. Risk terminologies • Issue: A risk which has already occurred is considered an issue. • Opportunities: Positive risks are called opportunities. A farmer has to take advantage of such positive risks. • Risk appetite: Amount and type of risk that a farmer is prepared to seek, accept and tolerate. • Risk tolerance: Farmers’ readiness to bear the risk treatments in order to achieve his objectives. 4
- 5. Risks and Returns A risk is always associated with future course of events • Greater the risk greater would be the return. • A risk without any return is a suicide. • Risk can be minimized but not totally eliminated • Risk can be managed and be kept at a lower side. • Risks are not inherently bad as they are often associated with profits. 5
- 6. 6 Why risk arises in agriculture? Risks are always omnipresent in agriculture due to the following factors: 1. Dependence on Nature (Production Risk) 2. Human Elements (Human/Personal Risk) 3. Markets (Price Risk / Market risk) 4. Government rules and regulations (Institutional Risk) 5. Financial Matters (Financial Risk) 6. Business risk (Aggregate of all the risks combined, except financial) Sources of risks in agriculture:
- 7. 1. Production risk or technical risk • Weather risk and technical risk are the two major components of production risk. • Changes in weather conditions leading to changes in production is called as weather risk. • With the changes in technology, there may be greater variations in output. This is called as technical risk. Example: - Insect-pest attacks - Vagaries of monsoon - Breakage / non-functioning of farm machinery at crucial times 7
- 8. 2. Human risk or personal risk • Farmers / farm labourers who operate the farm may become a source of risk to the farm profitability itself. • E.g.: Prolonged illness / death /non-availability of labourer/ key management employee or labour strike • Disputes at farm or within farming families leading to the disruption of farm work. 8
- 9. 3. Price risk or Market risk • Changes taking place in the markets (for both input supplies and output sale) may become a source of risk for the farmer. • E.g.: Price fluctuations and availability of inputs like labour, seeds, fertilizer, plant protection chemicals, plant growth promoters, etc. • Volatility in output prices of both main product and by-product are also a case of price risk. 9
- 10. 4. Institutional risk • Changes in government rules and regulations or policy orientation becomes a source of risk. Example: 50 IRS officers proposing ‘uncalled’ 40 %+ tax and COVID-19 cess on >10 lakh per annum earners on 25/04/2020– creating panic amid the pandemic. Other examples: Ban of export of agril. commodities (like wheat) Restricting movement of agricultural produce Imposing levy on certain commodities Acreage restrictions / Quantitative restrictions Ban on production in some regions Restrictions intended for resource utilization (like groundwater conservation) Subsidy and taxation changes. 10
- 11. 5. Financial risk • Financial risks increases with increased amount of borrowed money for farm business activities. • Financial risks may arise due to: Changes in rate of interest Changes in institutional policy regarding lending to a particular crop / enterprise Changes in repayment plans drawn by banks Non-institutional lenders forcing to make repayments in kind rather than cash. 11
- 12. 6. Business risk • Aggregate effect of {production + market + institutional risks} is called as business risk. • It is the aggregate effect of all the risks influencing the probability of the firm. • Business risk is the risk faced by the firm independent of the way in which it is financed. Hence, financial risk is not part of it. 12
- 13. What is risk management? • Risk management refers to the identification, assessment, and prioritization of risks (positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and / or impact of unfortunate events or to maximize the realization of opportunities. 13
- 14. Risk Management Strategies • Risk Mitigation: Actions taken to eliminate or reduce events from occurring, or reduce the severity of losses (e.g. water draining intervention, crop diversification, etc.) • Risk Transfer: Actions that will transfer the risk to a willing third party at a cost resulting in either full compensation or reduction in risk generated loss (e.g. insurance) • Risk Coping: Actions that help to cope with the losses caused by a risk event (e.g. government assistance, debt re-structuring) 14
- 15. Methods of Risk Management • 1. Retain: - take the risk – push the envelope; make no protective arrangements (e.g. storing the produce instead of immediate selling) • 2. Shift: - sell it off / insurance – Usually the one who holds the commodity bears the risk. Hence, it is better to dispose off the commodity at the earliest. Insurance may shift a part of or entire production risk from the farmers. Even contract farming would shift a part of the risk to the contractor. 15
- 16. • 3. Reduce: - prevention is always better – so usage of good agricultural practices may help in reducing the risks. For e.g.: • Intercropping (diversification) • irrigation • selection of resistant varieties • securing marketing contracts 16 Methods of Risk Management (Contd.)
- 17. • Self insure: - save for the rainy day – by keeping emergency reserves from previous year’s savings / profits to mitigate losses. • Avoid: - play it safe – by not selecting a particular enterprise not pushing the planting window; not increasing debt-asset ratio, declaring a crop holiday, etc. 17 Methods of Risk Management (Contd.)
- 18. Measurement of Risks • Measuring the risk makes it possible to establish the institutions and protective mechanisms for mitigation. • Risk = Consequence X Probability X Exposure • Probabilities can be attached to each event that can occur in a risky environment. • Consequence of each event must be known i.e. either profit or loss. • Exposure is the magnitude of loss / benefit that is likely to accrue to the firm. 18 There is no risk when: 1. Weighted average > simple average 2. Expected yield > average yield. 3. Lowest range and lowest variance
- 19. 19 Weighted Average > Simple Average There is no price risk for the underlying commodity 1. Estimating weighted averages:
- 20. 20 If expected value of yield is more than that of average yield, then there is no yield risk. 2. Estimating expected values:
- 21. 3. Using variability to select less risky enterprises • Selection of enterprises on the basis of small range and lowest variance. • Range: Measure of variability and it is the difference between lowest and highest possible outcomes. • Variance: It is the average of squared differences / deviations from the mean of the underlying variable. 21
- 22. Methods of reducing risks in farming 22 1. Diversification 2. Stable enterprises 3. Crop and livestock insurance 4. Flexibility 5. Spreading sales 6. Hedging 7. Contract farming 8. Minimum Support Prices 9. Increasing Net-worth
- 23. Define: 1. Risk 2. Uncertainty 3. Business risk 4. Risk management 5. Risk transfer 6. Institutional risk 7. Hedging 8. Price risk Write briefly: 1. Sources of risks in agriculture. 2. Risk management strategies for agriculture. 3. Risk measurement 4. Methods of risk management 23 Self-Assessment: