Risk Management Strategies
Farmers have many options for managing the risks they face, and most producers use a combination of strategies and tools. Some strategies deal with only one kind of risk, while others address multiple risks. Following are some of the more widely used strategies.
- Enterprise diversification assumes incomes from different crops and livestock activities do not move up and down in perfect correlation, so that low income from some activities would likely be offset by higher income from others.
- Financial leverage refers to the use of borrowed funds to help finance the farm business. Higher levels of debt, relative to net worth, are generally considered riskier. The optimal amount of leverage depends on several factors, including farm profitability, the cost of credit, tolerance for risk, and the degree of uncertainty in income.
- Vertical integration generally decreases risk associated with the quantity and quality of inputs or outputs because the vertically integrated firm retains ownership or control of a commodity across two or more phases of production and/or marketing.
- Contracting can reduce risk by guaranteeing prices, market outlets, or other terms of exchange in advance. Contracts that set price, quality, and amount of product to be delivered are called marketing contracts, or simply forward contracts. Contracts that prescribe production processes to be used and/or specify who provides inputs are called production contracts.
- Hedging uses futures or options contracts to reduce the risk of adverse price changes prior to an anticipated cash sale or purchase of a commodity.
- Liquidity refers to the farmer's ability to generate cash quickly and efficiently in order to meet financial obligations. Liquidity can be enhanced by holding cash, stored commodities, or other assets that can be converted to cash on short notice without incurring a major loss.
- Crop yield insurance pays indemnities to producers when yields fall below the producer's insured yield level. Coverage may be provided through private hail insurance or federally subsidized multiple peril crop insurance.
- Crop revenue insurance pays indemnities to farmers based on gross revenue shortfalls instead of just yield or price shortfalls. Several federally subsidized revenue insurance plans are available for major crops in most areas of the United States.
- Household off-farm employment or investment can provide a more certain income stream to the farm household to supplement income from the farming operation.
Most producers use a variety of farm management strategies and tools, and since risks and the willingness and ability to bear risks differ from farm to farm, so do the risk management strategies used.