AGRICULTURAL VALUE CHAIN: AN APPROACH TO AGRIBUSINESS 7
Risks and Sources of Risk of agricultural finance
Agricultural producers face a variety of risks and considerable uncertainty. This section identifies and defines sources and types of agricultural risks as well as tools available to manage those risks.
Agricultural producers face a variety of risks including production (yield), output price, and input price risk. Some of these risks are managed through production and financial decision-making while others are simply accepted as costs of doing business. Some risks can be managed thorough a variety of contractual and insurance-related products. In many cases, however, some risks are difficult to ameliorate such as those associated with interpersonal relationships that can generate personal physical, emotional, and financial stress among farm families and their employees. This section discusses sources of agricultural risk.
i. Production and Technical Risk are primarily caused by disease and extreme climate conditions including drought or low precipitation, excessive rainfall or flooding at planting time (prevented planting), precipitation or frost at or just before harvest (delayed harvest, sprouting), wind, insects, or hail. Unlike many other production situations, the use of specific quantities and qualities of inputs in an agricultural production process can result in different outcomes depending upon weather, insects, weeds, and a wide variety of interactions among these and other factors.
Changes in technology represent another aspect of technical risk. The adoption of a new technology itself is inherently risky, but failing to adopt emerging and successful technologies also generates the risk of not being competitive in a global economy.
ii. Output and Input Price Risk is substantial in agricultural markets because of worldwide supply and demand factors. Prices of agricultural commodities that are widely traded among countries are particularly subject to world market conditions. Changes in transportation, storage, and input costs also add to local price variability.
iii. Input Price Risk occurs because the prices of agricultural inputs often vary substantially over time. Fuel, fertilizer, and agricultural chemical prices fluctuate as a result of changes in demand for use in both agricultural and non-agricultural uses and because of variations in exchange rates and world production.
iv. Financial Risk generally refers to the variability of net farm revenue over a specific period of time (often one year or a production cycle) and is a major concern for agricultural producers, suppliers, and agribusinesses. On average, annual net farm revenues may be sufficient for agricultural producers to realize profits, but revenue variability may cause some agricultural producers to fail. If net farm revenue is small or negative in a given year, a producer will likely face financial difficulties. Volatile net farm revenue is particular difficult for farmers. Financial risk management is especially important for agricultural producers who acquire either short-term or long-term financing that requires scheduled interest and principal payments. Political Risk stems from changing regulatory and government actions as they relate to environmental concerns, business practices, financial issues, international trade relationships, and government support programs. Such issues are relevant even within stable, well-established political systems.
v. Personal Risk includes the threat of injury, illness, or death among managers or employees. Production agriculture is an inherently dangerous and hazardous occupation. Divorce and other personal relationship deteriorations can also cause financial distress.
How to mitigate the risks and Risk Management Tools
Agricultural producers use a variety of techniques to manage the variability of net farm revenues. In general, agricultural input costs and usage are much more stable from year to year than commodity prices and yields. Attempts to reduce net income variability, therefore, tend to focus on production (yield) and output price risk. Agricultural producers employ a variety of strategies to manage financial risks including investments in lower risk enterprises, enterprise diversification, maintaining relatively low debt-to-asset ratios and adequate financial reserves, and developing off -farm income sources.
i. Low Risk Investments represent an approach to managing risk. That is, risk can be mitigated by avoiding high risk endeavors. Investments in low risk activities, however, are usually correlated with relatively low average returns compared to higher risk investments.
ii. Enterprise Diversification is a risk management technique that involves investing in a variety of less than perfectly correlated investments within a portfolio. Combining less-than-perfectly correlated investments reduces variability of returns and may allow mean returns to be maintained. Many farmers produce a variety of crop and livestock products as a means of diversification; many of these diversification techniques also produce added benefits through improving soil characteristics, reducing weeds, and limiting insect infestations.
iii. Liquid Financial Reserves. Agricultural producers should maintain substantial financial reserves or liquid assets to help mitigate seasonality effects and reduce financial risk including the risk of crop failures.
iv. Off -farm Income. Agricultural producers and their family members are often employed in off - farm jobs. Off farm jobs that provides a more stable and, potentially, non-seasonal source of income. These employment opportunities can provide additional benefits including access to group health and life insurance.
v. Insurance Products help reduce risk. For example, formal property insurance markets transfer risk from producers to others with respect to fire, wind, theft, and other perils on buildings, machinery, and livestock. Furthermore, health and life insurance products are used to manage personal risk. Premiums paid to insurance companies for the transfer of this risk represent the costs of risk transfer. In addition, yield insurance can offset production risk and revenue insurance can offset combinations of yield and price risk.
vi. Contracts: Some producers forward contract the delivery of their crops and livestock to various agribusiness entities. In most cases, forward contracts stipulate specific prices to be paid upon delivery of the commodity. Contracts often include a variety of quality specifications and are legally enforceable. In addition, producers may forward contract for agricultural inputs.
Government Risk Management Programs
In some countries, governments establish minimum prices for agricultural commodities. These programs provide minimum price guarantees and a variety of farm income support for producers of some commodities. Many countries provide ad hoc Disaster Aid programs that offset losses caused by catastrophic weather events.