A Dicey Proposition
An excellent understanding of probability is essential for effective risk management. Not long ago, we released the article "Coining Some Terms." We hope this article makes a useful follow-up and supplement to "Coining Some Terms." In this article, rather than using a coin, we'll use a simple six-sided die.
One of the most critical tools for risk management that comes from probability theory is fair value. We can use fair value to better understand, and therefore harness a range of uncertain future outcomes. In the case of our six-sided die, let's assume we want to know what the fair value of a bet that pays one dollar for every spot the dice shows after a single roll. The proper way to calculate the fair value is to multiply the amount of each outcome time that outcome's probability. Which looks like this:
(1/6*1)+(1/6*2)+(1/6*3)+(1/6*4)+(1/6*5)+(1/6*6) = 3.5
I've always found it interesting that the fair value of an uncertain future outcome can be, and often is, not a potential outcome (there is no 3.5 on a standard six-sided die). We touched on this concept in an earlier article entitled "Risk Premiums."
By understanding the fair value of a bet, we can determine if the wager has an edge (A concept we introduced in "The Relationship Between Risk, Reward, Edge, and Risk Management"). For instance, if we could pay $3 to roll the dice once, and receive $1 for each spot, we would have $0.50 of edge. We'd also have a max loss of $2 and a max win of $3. These conditions make for an excellent bet, but it may not seem exciting--that part is still to come.
Admittedly, it might seem like we're a long way from the farm, but we're closer than you think. If we multiply the above bet by $100,000, the edge becomes $50,000, with a max loss of $200,000 and a max win of $300,000. That's starting to sound a lot more like farming, and hopefully, I've still got your attention, because here comes the exciting part:
If instead of multiplying the bet by 100,000, we agree to make the smaller $1 bet 100,000 times, things change drastically. The edge stays $50,000, only now it's almost certain to be realized. By shifting from a single large bet to many smaller bets, the advantage becomes much more real and much less variable. Effective risk management works similarly. Rather than making a massive bet with a highly-variable outcome, effective risk management lessens the stakes while having a low impact on a producer's overall edge.
At Quartzite Risk Management LLC, we help producers like you stay in the game for the long run. We're experts in working with producers to create and implement effective risk management strategies. If you're interested in learning more, contact us today or read more about our Dynamic Grain Price Risk Management program.
