Farm-level evidence on risk-balancing strategies of Illinois grain farmers against increasing income risk

The Risk-Balancing Hypothesis, developed from both the analysis of the firm's equilibrium conditions and through the expected utility mean-variance framework, presents a risk management option that entails adjustments in the farm's financial structure in response to modifications in its business risk conditions. Notwithstanding the concept's theoretical foundation as well as its strong intuitive appeal and analytic value, the Risk-Balancing Hypothesis lacks solid empirical support.; This study tests the hypothesis through an econometric analysis of longitudinal farm-level data on Illinois grain farms. Using a straightforward risk-balancing measure based on the correlation of historical levels of business and financial risk measures, the results confirm that more than half of the farmers indeed balanced these risks over a seventeen-year period. Estimation results indicate that risk-balancing farmers tend to be older, operate larger farms, have higher leverage and leasing ratios and are more financially efficient. Moreover, the results suggest compatibility between risk-balancing and such risk management strategies as insurance protection, crop specialization, enterprise diversification, and marketing strategies.; The analytical framework is extended to a simulation-optimization model that takes on a more forward-looking perspective. The goal is to prescribe an optimal strategic plan that allows synergy between risk-balancing and other risk management strategies. The programming model was applied to four farm scenarios. The Base Farm scenario employs standard strategies that include risk-balancing, cash leasing of farmland and investing in nonfarm assets. The most sophisticated scenario, the Complete Farm model, employs share leasing and forward contracting strategies in addition to the standard strategies. The programming models yielded risk efficient final net worth solutions across four classes of risk-averse farmers. The Complete Farm model resulted in the lowest relative variability of final net worth for the two highest classes of risk aversion. These results demonstrate the existence of synergy between risk-balancing and other strategic plans. The risk-reducing mechanisms of most strategies combine more effectively with the profit-generating capacities of some strategies to produce optimal results. Moreover, this study finds that risk-balancing becomes a more significant strategy among highly risk-averse farmers as reflected in the substantial reduction in their leverage ratios compared to less risk-averse decision-makers.