Farm planning under risk : an application of the captial asset pricing model to New Zealand agriculture

Abstract

With the removal of many forms of government intervention from the agricultural sector, risk management has become an increasingly important issue for New Zealand farmers. One strategy for managing risk is enterprise diversification, and there has been a great deal of research on how this might be done most appropriately. A recent suggestion is that the use of the Capital Asset Pricing Model (CAPM) may provide appropriate information.

The CAPM can be used to determine the proportion of systematic (or non - diversifiable), and non - systematic (or diversifiable) risk associated with each activity, the expected return for each activity, and whether activities are being compensated adequately for the amount of systematic risk associated with them.) Ultimately, it could be used to generate optimal farm plans using much more simplified computational procedures than more traditional quadratic programming approaches. Unlike the traditional approaches to farm planning, the CAPM is able to measure the contribution that each farm activity makes to the variance of the total farm portfolio.

A Farm Sector Capital Asset Pricing Model (FSCAPM) was developed for New Zealand mixed cropping agriculture. It was observed that the model results were sensitive to various components of the model, including the choice of a farm sector portfolio, the way the activity returns were measured and whether the activity returns were deflated.

An application of the preferred variant of the FSCAPM to the Lincoln University Mixed Cropping Farm showed that high levels of systematic risk were associated with activities on this farm. This suggests that off - farm investment might be a more feasible strategy than on - farm diversification for reducing risk on the farm. The results also showed that all the farm activities examined were being adequately compensated for the level of systematic risk it was accepting.

This study makes an addition the limited research which has been undertaken on how to apply the CAPM framework to an agricultural setting.