Facilitator’s Notes – What is Risk?
AgVentures
Grain Marketing
Facilitator’s Notes
What is Risk?
TIME ALLOWED: 30 – 40 minutes.
INTRODUCTION:
What one hears the words “price risk”, it usually conjures up thoughts of low outputs prices or
high input prices. Risk, whether price risk or some other kind of risk, is often defined as the
potential that undesirable outcomes might occur. Certainly, low output prices or high input
prices are an undesirable outcome in a grain farming operation. Price risk could also be
associated with prices being more variable. Risk exists if there are alternative outcomes and risk
increases if you are unaware of all the potential outcomes, the probability of occurrence and the
cost of a negative outcome.
OBJECTIVE(S):
1. Participants will understand a working definition by learning about potential outcomes
that could occur & the probability of each outcome, and/or the cost of negative outcomes.
2. Participants will learn the fundamental difference between Risk Management, assuring an
outcome and Price Risk Management, which is assuring a price.
3. Participants will leave with the knowledge of how to evaluate price risk management
decisions.
INSTRUCTIONS:
PowerPoint presentation and/or overheads: Make overheads of exercise 1-3 and distribute hard
copies along with the average monthly prices of corn from 1998 – 2003 provided to you in the
excel spread sheets.
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Facilitator’s Notes – What is Risk?
Understanding Probability
One of the foundation concepts of risk is probability or the language of uncertainty is probability.
The sooner participants understand the concept of probability, the sooner they will understand
price risk and price risk management. With respect to price risk, a particular type of probability,
the “normal” distribution, is especially important. Slide 7 shows an example of a normal
distribution and its typical mountain shape.
You should start the presentation by giving the exercise sheets for exercise 1 to 3.The goal of the
opening exercise is to get the participants to create the normal distribution on their own. The goal
is to have participant trace out what the think the distribution of monthly average prices of corn
has been since 1998. Provide the participants with the actual price sheet or the price data from
1998-2003 corn monthly average prices. Ask participants what they think the lowest range of
prices has been since 1998, low third, average, top third and highest. They have to record these in
the exercise sheet. Then, ask the participants what percent of time each of their estimates
occurred and place a dot on the vertical axis and connect. The right answer is, of course, a
mountain shaped distribution like. So, without even realizing it, you already have the participants
thinking in terms of probability, and they now have planted a seed for a visual understanding of
price risk.
The normal distribution is a cornerstone of price risk. As slide 7 shows, the price values near the
center of the distribution have a high likelihood of occurring while those prices much higher and
much lower can occur, but the likelihood of their occurrence is much less.
Although they may not recognize it by name, most producers will intuitively understand the
interpretation of the normal distribution, and in-fact they make decisions based on a normal
distribution most every day. For example, they make decisions on when to make hay based on
the probability of rain. They plan on production will vary around that average level. They also
know full well that the likelihood (probability) of much higher levels of production or much
lower is possible, but the chance is much less.
So, the goal is to link the work “probability,” and its significance to price risk, with what they
already intuitively understand. Exercises 1-3 will hopefully begin to accomplish the goal.
1. Exercises 1, 2, and 3: Ask the participants to complete exercises 1 and 2. Provide them
with the corn price data that is given in the excel worksheet. It makes no difference for
this exercise whether they write down a single price (e.g., average price of $2.00) or write
down a range of prices (e.g. average price between 2.05 – 2.15). A suggestion is to have
them limit their range to 10 cents. Next have the participants plot their answers to
exercises 1 and 2 onto the blank graph on exercise 3; and connect the dots. Once
participants have completed the exercises, then tell them that you will get back to their
findings in a few moments.
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Facilitator’s Notes – What is Risk?
What is Risk?
2. [Slide 2-3]: When one hears the words “price risk”, it usually conjures up thoughts of low
output prices or high input prices. Risk, whether price risk or some other risk, is often
defined as the potential that undesirable outcomes might occur. Certainly, low output
prices or high input prices are an undesirable outcome in a grain farming business. Price
risk could also be associated with prices being more variable. This latter thought on
variability is getting closer to the definition of risk.
3. [Slide 4-6]: Slide 4 shows a flow chart of terminology for risk. Risk begins with an
event, which is an occurrence or simply “something happens”. Events can be external or
internal. External events occur outside of the manager’s control, but the manager feels the
impact of the event. Weather, government legislation, or world production are all outside
of the producer’s control, but all have impacts that will be felt. Internal events are those
caused by a decision made by the producer such as the decision to plant more acres or
not, apply a herbicide, hiring an employee, buying a tractor etc.,
An outcome is a consequence, result, or impact of some event. For example, a weather event
such as rainfall, hot weather, or humidity can result in various outcomes for corn production.
The event of not applying herbicide could result in various outcomes such as reduced corn
production, or no impact.
Probability is the likelihood that any outcome will occur. For example, the probability of the
weather event such as rainfall could be 15, 30, or 60 percent. Probability is at the heart of the
definition of risk. As humans, and especially as agricultural producers, we deal with and
make decisions based on probability every day – probability of rain, probability of disease
spread, probability of achieving high yields etc., How many times have your plans for the day
changed because the probability of rain or shine changed?
With respect to price risk, an event might be corn production in a given year. Potential
outcomes include no change from that of average yield in the previous year, substantial to
moderate increase or decrease in output, each having a corresponding, but opposite, impact
on price. Each of these outcomes has some likelihood (probability) of occurring.
[Slide 7]: Risk exists anytime there is the potential for alternative outcomes because presumably
there is come outcome(s) less desirable. The chance of those desirable outcomes occurring is the
risk you face. Slide 7 shows the risk you face increase the more you don’t know and understand:
 All the potential outcomes that could occur,
 The probability of each outcome occurring, and/or
 The cost of negative outcomes.
Said another way, the more you do know and understand about these three characteristics of risk,
the better long term risk manage you are likely to be. You will not always make the right
decision, but your likelihood of making smart decisions will improve the more you understand
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Facilitator’s Notes – What is Risk?
potential outcomes, probability of each outcome occurring and the cost to you of a negative
outcome.
For example, do you know?
 The range of average monthly corn prices that have occurred since 1998, i.e., what are the
potential price outcomes (Please review the corn monthly price sheet provided).
 The probability that a particular price or price range occurred?
 And fully understand the implications too your operation and family if a negative price
outcome occurs?
[Slide 8]: This slide shows all different kinds of risk a grain producer faces in his operation. The
financial health or success of business depends on successfully managing all kinds of risk. Here
in this workshop our focus is to understand more about the price risk.
[Slides 9-11]: Slides 9-11 demonstrates the concept of price risk via example of average monthly
corn prices from 1998 through October 2003.
Part of manager’s efforts in reducing price risk is simply being aware of the potential outcomes
that could occur. In this case, it is assumed that price since 1998 may be an indicator of what the
next couple of years may potentially offer. While certainly not full proof, history can often be a
good indicator of the future. Form this historical prices (70 observations) the average monthly
prices of corn ranged from a minimum of $1.52 to a maximum of $2.56. The difference or range
is $1.04. The average price is $2.03 with a standard deviation of $0.24. Some years tend to be
higher price years that often followed by few years of low prices. Certainly, there is great
variation in prices from year to year and also within the same marketing year from month to
month.
At this point, ask the participants to refer back to the exercise they completed at the very
beginning and have them compared their graph (slide 3) with the solid line on slide 8. If their
graph has a similar shape (mountain shape) then the participant has just passed the statistics
course on understanding the concept of risk as it illustrates that there is more than one potential
outcome resulting from any event, and that there is a different likelihood (probability) associated
with each outcome. You might also note that the long tail to the right side of the distribution is
the result of high monthly average prices during early part of 1998 and the 2003. Understand that
in any given marketing year the prices will often assume the shape of a mound that will be
described by normal distribution.
Slide 11 gives the normal distribution with 68% of the time the monthly average prices falling in
between $1.79 and $2.27 range. The 90th percentile value of $2.37 tells that 90% of the time the
observed values fell below this value. Only for limited times prices were above value. Likewise,
the 75th percentile value is $2.21 and 25th percentile value is 1.88. The average price is $2.03.
The facilitator may want to emphasize to the reader, that these are actual average monthly prices,
i.e. this is reality.
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Facilitator’s Notes – What is Risk?
What is Price Risk Management?
[Slide 12-13]: These slides illustrate the idea that risks increases the more you don’t know the
likelihood of particular outcomes. In the very least your ability to make good pricing decisions
will improve if you understand the probability of potential price outcomes.
[Slide 14]: Stated simply, Risk Management is assuring an outcome, and thus Price Risk
Management is assuring a price. There are various ways to define price risk management, but
slide 14 states the definition in its simplest form, and that is assuring what the outcome of price
will be. If you lock in a price then you have assured your price. You now no longer have any
price risk. You of course still have production risk and etc., but you are now assured of the price
you will get, i.e., you know with 100% probability what your outcome will be.
[Slide 15]: As the diagram on slide 15 shows, a way to visually think about this is that risk
management is trying to “squeeze” in the probability distribution, i.e., assuring an outcome. By
squeezing the distribution, you have a higher and higher probability of getting some price. If you
lock in a price by hedging, then you have squeezed this distribution by assuring yourself a
locked-in price. Price risk management is changing the distribution of prices that you face.
[Slide 16-17]: These two slides will show what happens to the distribution when you establish a
price floor or a price range using a fence strategy. Basically you are limiting the potential
outcome space to more towards beneficial results.
[Slide 18]: Provides the five primary strategies of risk management such as reduce, transfer,
avoid and do nothing.
While there are many ways to conduct price management, whichever model you choose, it should
include:
 Awareness of the price risk you face,
 Evaluating prices via
- What you uniquely need for you operation and family
- What the market traditionally provides
 Management
- How do I secure and evaluate a price and/or strategy
[Slide 19-20]:
Now you understood what are risk and its components. Slide 20 give action plan to manage price
risk These steps are as follows: Be aware of risk, evaluate alternatives, decide the strategies,
implement the chosen strategy and finally control to make sure the things are working the way
they are planned.
[Slide 21]: An important point to remember is that there is a team of people ready to help in all
these steps of price risk management. You are the CEO of this team, but you are not alone.
There are other team members out there ready to aid you in evaluation your price risks,
developing courses of action, and implementing your decisions.
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