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A model for the optimal risk management of (farm) firms

Author

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  • Svend Rasmussen

    (Department of Food and Resource Economics, University of Copenhagen)

Abstract

Current methods of risk management focus on efficiency and do not provide operational answers to the basic question of how to optimise and balance the two objectives, maximisation of expected income and minimisation of risk. This paper uses the Capital Asset Pricing Model (CAPM) to derive an operational criterion for the optimal risk management of firms. The criterion assumes that the objective of the firm manager is to maximise the market value of the firm and is based on the condition that the application of risk management tools has a symmetric effect on the variability of income around the mean. The criterion is based on the expected consequences of risk management on relative changes in the variance of return on equity and expected income. The paper demonstrates how the criterion may be used to evaluate and compare the effect of different risk management tools, and it illustrates how the criterion should be applied to integrate risk management at the strategic, tactical and operational level. The paper concludes that the derived criterion for optimal risk management provides a valuable theoretical tool for the economic evaluation of the consequences of risk management.

Suggested Citation

  • Svend Rasmussen, 2013. "A model for the optimal risk management of (farm) firms," IFRO Working Paper 2013/10, University of Copenhagen, Department of Food and Resource Economics.
    • Handle: RePEc:foi:wpaper:2013_10
    as

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    File URL: http://okonomi.foi.dk/workingpapers/WPpdf/WP2013/IFRO_WP_2013_10.pdf
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    References listed on IDEAS

    as
    1. María Bielza & Alberto Garrido & José M. Sumpsi, 2007. "Finding optimal price risk management instruments: the case of the Spanish potato sector," Agricultural Economics, International Association of Agricultural Economists, vol. 36(1), pages 67-78, January.
    2. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    3. Gilbert Nartea & Paul Webster, 2008. "Should farmers invest in financial assets as a risk management strategy? Some evidence from New Zealand ," Australian Journal of Agricultural and Resource Economics, Australian Agricultural and Resource Economics Society, vol. 52(2), pages 183-202, June.
    4. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    5. G. Hanoch & H. Levy, 1969. "The Efficiency Analysis of Choices Involving Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 36(3), pages 335-346.
    6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Annie Dimitrova, 2024. "Risk Management in Production Structures – Realities, Challenges and Opportunities," Economic Thought journal, Bulgarian Academy of Sciences - Economic Research Institute, issue 3, pages 353-366.

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    More about this item

    Keywords

    firm value; CAPM; optimal risk management; return on equity; risk; expected income;
    All these keywords.

    JEL classification:

    • Q14 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Agricultural Finance
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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