Step 7: Choose the "Best" Risk Management Alternative

Authors: HOAG, D - COLORADO STATE UNIVERSITY; Fathelrahman, Eihab; Ascough Ii, James

Submitted to: Book Chapter
Publication Type: Book / Chapter
Publication Acceptance Date: 11/22/2008
Publication Date: 10/20/2009
Citation: Hoag, D.L., Fathelrahman, E.M., Ascough II, J.C. 2009. Step 7: Choose the "Best" Risk Management Alternative. Book Chapter.

Interpretive Summary: The ultimate purpose of the SRM tactical phase is to choose how to manage risk. Prior to this stage, we determined the sources of risk, identified the relevant management actions and estimated the likelihood of all known outcomes. Next, we combine this information with your personal risk preferences to construct a payoff matrix, which will be used to determine the best management alternative for you, given your personal circumstances. The tools in this chapter take advantage of the payoff matrix in order to rank management actions. We can rank any management options you like, but we have to account for your risk personality when doing so. For example, we can help you compare selling on the cash market to hedging your crop and to forward contracting your crop. Perhaps the cash market makes the most money, followed by hedging and forward contracting. But forward contracting provides the most stable income, followed by hedging and then the cash market. How do you choose the best strategy for you? Every person is unique; so you might look at risk a little differently than someone else. Choosing a strategy depends upon your strategic resources, goals and objectives and your attitude about risk taking. Part 1 of this chapter illustrates the personal side of risk management using EWS Farms as a case study. Aaron ranks three options for marketing his corn: cash market sale, hedging in the futures market and forward pricing. Part 2 will explain how to rank risk management options. Several different ways to rank risk are described and included in the Risk Navigator tool called Risk Ranker. Each of these methods takes advantage of a different way of thinking about risk. Lastly, we discuss when you should use information about your risk preferences. Many of the methods presented do not require that information, but sometimes it is absolutely necessary if you want to rank one management action over another. We describe three tools in Part 3: Risk Ranker, Value at Risk (VaR) and the Risk Efficiency Tool (RET). As in the previous chapters, we demonstrate these tools using EWS Farms as an example.

Technical Abstract: The ultimate purpose of the SRM tactical phase is to choose how to manage risk. Prior to this stage, we determined the sources of risk, identified the relevant management actions and estimated the likelihood of all known outcomes. Next, we combine this information with your personal risk preferences to construct a payoff matrix, which will be used to determine the best management alternative for you, given your personal circumstances. The tools in this chapter take advantage of the payoff matrix in order to rank management actions. We can rank any management options you like, but we have to account for your risk personality when doing so. For example, we can help you compare selling on the cash market to hedging your crop and to forward contracting your crop. Perhaps the cash market makes the most money, followed by hedging and forward contracting. But forward contracting provides the most stable income, followed by hedging and then the cash market. How do you choose the best strategy for you? Every person is unique; so you might look at risk a little differently than someone else. Choosing a strategy depends upon your strategic resources, goals and objectives and your attitude about risk taking. Part 1 of this chapter illustrates the personal side of risk management using EWS Farms as a case study. Aaron ranks three options for marketing his corn: cash market sale, hedging in the futures market and forward pricing. Part 2 will explain how to rank risk management options. Several different ways to rank risk are described and included in the Risk Navigator tool called Risk Ranker. Each of these methods takes advantage of a different way of thinking about risk. Lastly, we discuss when you should use information about your risk preferences. Many of the methods presented do not require that information, but sometimes it is absolutely necessary if you want to rank one management action over another. We describe three tools in Part 3: Risk Ranker, Value at Risk (VaR) and the Risk Efficiency Tool (RET). As in the previous chapters, we demonstrate these tools using EWS Farms as an example.