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Lesson-21 Risk Management In Agribusiness
Agriculture production and farm incomes in India are frequently affected by natural disasters such as droughts, floods, cyclones, storms, landslides and earthquakes. Susceptibility of agriculture to these disasters is compounded by the outbreak of epidemics and man-made disasters such as fire, sale of spurious seeds, fertilizers and pesticides, price crashes etc. All these events severely affect farmers through loss in production and farm income, and they are beyond the control of the farmers. With the growing commercialization of agriculture, the magnitude of loss due to unfavorable eventualities is increasing. The question is how to protect farmers by minimizing such losses. Apart from production the risk is also involved in marketing of produces, because of high variation in prices. Therefore, farmers, traders, processors and other agencies involved in agribusiness use various risk management strategies. In this chapter you will understand the meaning of risk and uncertainty, dimensions of risks and management of the risk.
21.2 RISK AND UNCERTAINTY
Risk: It is a situation when all possible outcomes are known for a given management decision and probability associated with each possible outcome is also known. This is measurable through probability concepts. Ex: Occurrence of pest and disease, fluctuation in market prices etc.
Uncertainty: This situation prevails when all the possible outcomes of events are unknown, therefore neither the probability nor the outcomes are known. It is not measurable. Ex: Occurrence of flood, drought etc
In this chapter we are concerned about only risk in agribusiness, while uncertainty is beyond the scope of this course.
21.3 DIMENSIONS OF AGRICULTURAL RISKS
Farmers face a number of risks which are often interconnected. Five types of risk are generally considered in agriculture, according to their sources:
Production risks, concerning variations in crop yields and livestock production, affected by a range of factors: weather conditions/climate change, pests, diseases, technological change as well as management of natural resources such as water
Market risks, associated with variability in output price (mostly), also input price variability and integration in the food supply chain (with respect to quality, safety, new products, etc.)
Regulatory risks connected with the impact of changes in agricultural policies (e.g. subsidies, regulations for food safety and environmental regulations) or trade policies: a change in government action, which is at odds with what farmers expected, may have a negative impact on their income
Financial risks resulting from different methods of financing the farm business, subject to credit availability, interest and exchange rates, etc.
Human resource risks, associated with unavailability of personnel.
Production risk, market risk and financial risks are usually considered the most important in agriculture and are discussed below. Policies are part of the solution in addressing these risks but are also associated with regulatory risks.
21.3.1 PRODUCTION RISKS OR TECHNICAL RISK
In industrial business we have a technical input-output relationship with known quantity of output for a given quantity of input i.e., the production practices are standardized in industrial production. Such type of relationship does not exist in agricultural production.
Output of crops and livestock is subject to change due to weather, diseases, insects, weeds and inadequate technology. These factors cannot be predicted accurately and hence results in the variability of the output.
Thus, the production-risk is not confined to any one factor, but combination of different factors.
However, weather risk and technical risk are the most important components of production risks.
21.3.2 MARKET AND PRICE RISK
Types of Market Risks: The risks associated with marketing are of three types, namely physical risk, price and institutional risk.
Physical risk includes loss of quantity and quality. It may be due to fire, rodents, pests, excessive moisture or temperature, careless handling, improper storage, looting or arson.
Price risk associates with fluctuation in price from year to year or within the year.
This is a change in any policies, or rules and regulation ruling the marketing aspects.
21.3.3 FINANCIAL RISK
This type of risk increases with increased amount of borrowed money in the farm business
Financing the production processes and storing the commodities under scientific management require large amounts of borrowed capital
Hence a careful analysis is to be made considering all type of risks
21.4 MEASURES TO MANAGE PRODUCTION RISKS
There are various ways to manage or mitigate the production risks. The major measures are discussed below.
This measure applies to those involved in production of primary agricultural produces, viz, farmers, cooperatives and corporate.
Main objective of diversification is that if there is a loss in one enterprise, that would be compensated with the gain in other enterprise
Selection of suitable crop and livestock enterprises is the first step in diversification
The enterprise having less income variability should be selected
Corporate companies involved in farming business may use risk programming models and game theory models to formulate whole farm plans under different risk situations
Insurance is the coverage by contract in which one party agrees to indemnify or reimburse another for loss that occurs under the terms of the contract. Agricultural insurance is considered an important mechanism to effectively address the risk to output and income resulting from various natural and manmade events. Agricultural Insurance is a means of protecting the agriculturist against financial losses due to uncertainties that may arise agricultural losses arising from named or all unforeseen perils beyond their control (AIC, 2008).
Agricultural insurance is one method by which farmers can stabilize farm income and investment and guard against disastrous effect of losses due to natural hazards or low market prices. Crop insurance not only stabilizes the farm income but also helps the farmers to initiate production activity after a bad agricultural year. It cushions the shock of crop losses by providing farmers with a minimum amount of protection. It spreads the crop losses over space and time and helps farmers make more investments in agriculture. It forms an important component of safety-net programmes as is being experienced in many developed countries like USA and Canada as well as in the European Union.
21.4.3 AGRONOMIC PRACTICES
To reduce production risk agronomic practices like, selecting suitable varieties, crop rotations, mulching etc., should be adopted.
21.5 MEASURES TO MANAGE MARKET RISKS
21.5.1 Physical Risk
a. Reduction in Physical loss through fire proof storage, proper packing and better transportation.
b. Transfer of physical losses to Insurance companies.
These measures are applicable to both farmers and other agencies in the business like processors also.
21.5.2 Price Risk
Minimum Support Prices (MSP) is a vital tool in helping farmers and consumers in achieving food security while extending remunerative prices to the farmers for their produce.
Dissemination of price information to all sections of society over space and time.
Effective system of advertising and create a favorable atmosphere for the commodity.
Creation of a Credit Risk Management Fund model for plantation crops seeks to institutionalize the credit risk of farmers in the event of adverse price movement of plantation crops is required.
Operation of speculation and hedging : Futures trading, forward market
Speculation: Purchase or sale of a commodity at the present price with the object of sale or purchase at some future date at a favorable price.
Hedging: It is a trading technique of transferring the price risk. “Hedging is the practice of buying or selling futures to offset an equal and opposite position in the cash market and thus avoid the risk of uncertain changes in prices” (Hoffman).
Futures Trading: It is a device for protecting against the price fluctuations which normally arise in the course of the marketing of commodities. Stockists , processors or manufactures utilize the futures contracts to transfer the price risks faced by them.
Contract farming is also one of the measure which safeguard both farmer and agribusiness firm against production and market risks
It is a bipartite agreement between farmer and industry to supply the agreed quantity at a specified date. Services provided by sponsoring firms range from supply of inputs, extension service, quality monitoring to purchase of output. However the absence of common legally binding contractual arrangement gives the way for violation the contract on both sides.
Production risk of farmer is minimized through the better technology and management practices provided by the processing company while the price risk of farmer is mitigated due to pre-agreed prices. Normally, processing company also faces the risk in the absence of contract farming due to non availability of timely and quality raw material for processing. Through the contract farming system, this risk may also be minimized.
Agriculture Insurance Company of India Ltd. (2008): www.aicofindia.org accessed 2006 to 2008.