Dynamic Risk Management Under Credit Constraints

The vast majority of previous studies on farmers' optimal risk management behavior have used static models and on the most part ignored use of borrowing and lending as an alternative method of managing risk In this paper we develop a stylized multi-period risk management model for a risk averse farmer who can use revenue insurance to manage risk and also borrow and lend subject to a credit constraint. The model is applied to an example farm from Adair County in Iowa and the results provide three important messages. First, contrary to the full coverage of actuarially fair insurance result expected from using purely static analysis, at low revenues, insurance coverage may not be taken in the absence of debt. Second, if debt is available, full coverage will be taken at all revenue states and, third, premium wedges at reasonable levels have larger impact on coverage if debt is available because they eliminate the incentive to use insurance. Results also show that use of borrowing and lending for consumption smoothing reduces extant risk by approximately 77% while use of insurance only reduces risk by approximately 30%.