# 1 Introduction

The capability of farm households to smooth their incomes through diversi...cation heavily relies on the risk covariance between possible income sources. In subsistence economies, it is widely recognized that returns from various activities, particularly in rural areas, are to a great extent positively correlated. This signi...cantly limits the e¢ cacy of income diversi...cation in achieving a smooth level of consumption across time and space. Therefore, the availability of su¢ cient ex post mechanisms is imperative for the survival strategy of farm households to prevent automatic translation of income variability into consumption variability. In this respect, a strategy worth considering is accumulation and liquidation of assets such as livestock, grain stocks, farm tools and implements, cash holdings and so forth. The study of the extent to which farm households use these assets, which are also directly employed in agricultural production, as a coping mechanism has recently become an important topic of analysis. The central focus of the analysis has been the investigation of the savings and portfolio choice of farmers.

Empirical studies on permanent income in poor agricultural societies (for example Bhalla, 1979; Wolpin, 1982; Deaton, 1992; and Paxson, 1992; Park, 2006) con...rmed some but not all aspects of the traditional permanent income - life cycle hypothesis, i.e. farm households save a signi...cant fraction of transitory income in order to stabilize their future consumption. In the same vein, Udry (1995) presented evidence from agricultural households in Northern Nigeria supporting the hypothesis that assets can be used as a bu¤er in ex post risk coping strategies. However, the analysis is based on the assumption that households are not constrained in their borrowings and the income process is given exogenously, independent from the decision of households to accumulate assets. Deaton (1991) partially addressed the problem by developing a theoretical framework for savings under uncertainty on the assumption that consumers are not allowed to borrow at any point in time. The predictions of the model highlight the role of liquidity constraints in providing additional incentives to hold assets as bu¤er stocks.

Furthermore, other studies have extended the framework by jointly considering consumption and production decisions under uncertainty and restrictions on borrowing. Rosenzweig and Wolpin (1993) consider investments in bullocks in India, which is the most important source of animal traction that can also be used for consumption smoothing. They ...nd that sales of bullocks often serve as a bu¤er stock although substantial underinvestment in bullocks is observed due to the risk averse nature of farmers combined with their inability to borrow, which, in turn, lead to losses in output and further ‡uctuations in income. Dercon (1998) also ...nds similar results using data from Western Tanzania. In spite of its role in production as well as a bu¤er for future contingencies, investment in cattle is impeded by incomplete credit markets and the need for lumpy investments. As a result, poor households are forced to become involved in less risky 1