Rationalising Risk Assessment: Applications to Agricultural Business

Abstract

To concentrate on treating the most serious risks, methods of business risk management usually seek to identify the main risks and to assess their relative importance. Risks are typically assessed in terms of their chances of occurrence and the severity of their consequences. The assessments may be performed by qualitative, semi-quantitative or quantitative analysis. This paper is focussed on quantitative methods, requiring assessments of specific probabilities and values for consequences. There are problems with conventional risk assessment. For some risks there may be no specific adverse event. And often the severity of possible adverse consequences is uncertain. Typically, neither the decision maker’s risk aversion nor possible upside outcomes are taken into account. Moreover, the usual one-at-a time approach means that stochastic dependencies and scope for risk spreading through diversification are also ignored. Risk assessment by certainty equivalents of losses (CELs) is proposed to overcome some of the above-mentioned limitations. The calculation of the CELs is explained and illustrated with agricultural business examples, before limitations of downside risk assessments and the effects of ignoring upside benefits are addressed. An extension of the approach to a portfolio setting is described which accounts for stochastic dependencies and diversification benefits. The suggested approach is extended to deal with the risk of bankruptcy.