Intertemporal Risk Management Decisions of Farmers under Preference, Market, and Policy Dynamics

Abstract

This paper adapts a generalized expected utility (GEU) maximization model (Epstein
and Zin, 1989 and 1991) to examine the intertemporal risk management of wheat producers in
the Pacific Northwest. Optimization results based on simulated data indicate the feasibility of the
GEU optimization as a modeling framework. It further extends the GEU model by incorporating
a welfare measure, the certainty equivalent, to investigate the impacts of U.S. government
programs and market institutions on farmers’ risk management decisions and welfare. A
comparison between the GEU and other expected utility models further implies GEU has the
advantage of specifying farmers’ intertemporal preferences separately and completely. Impact
analysis results imply that farmers’ optimal hedging is sensitive to changes in the preferences
and the effects of these preference changes are intertwined. Target price and loan rate levels,
offered by certain government payment programs, can lead to the substitution of government
programs for hedging. The evaluation of current risk management tools shows both crop
insurance and government payments can improve farmers’ welfare significantly. Government
payment programs have a greater effect on farmers’ welfare than crop insurance and crop
insurance outperforms hedging.

Classification Code: Q14, D9, C61

Keywords: generalized expected utility, risk management, multi-period production, dynamic
optimization, intertemporal preference, market institution, government payments

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