Extensive grazing activities in the Mediterranean area will have to confront an increasing risk of drought. This threat poses a challenge to the long-term viability of these activities that play an important role in rural development and have traditionally shaped highly valued ecosystems such as the Dehesa landscape in the Iberian Peninsula. The aim of this research is to assess the economic impact of drought on this extensive livestock farming system and evaluate the potential of adaptation strategies such as reducing the stocking rate. A dynamic and stochastic bioeconomic model is developed to account for the complex climatic, ecologic and economic relationships at play during drought.We simulate the 1999–2010 weather time series to characterize seasonal patterns and evaluate the risk caused by drought spells. We assess the consequences of drought in terms of duration, frequency and intensity, finding that economic losses increase at an increasing rate with long lasting droughts. Our findings reveal different patterns between climate and economic risk variables. The risk of a climate shock concentrates in spring and the beginning of autumn while the risk of suffering economic losses occurs with a 3–4weeks delay and lasts for a longer period of time. We integrate Monte Carlo routines in our simulation model to assess risk exposure and propose the use of Value-at-Risk to capture downside risk at different thresholds. Our simulation results show that the farmer may have to confront annual economic losses above 22.9% with a 5% probability in the current or baseline scenario. Finally, we use the model as a tool to evaluate the potential of adaptation strategies such as increasing or reducing the stocking rate. We find that the former has rather limited impact on average income as compared to the later but both show significant impacts on risk exposure, which may entail important economic consequences. In particular, we find that increasing the stocking rate by 20% decreases the probability of incurring moderate losses, from 45.0% to 40.6%. Furthermore, it also increases the probability of favourable outcomes, from 50.0% to 52.0%. However, this comes at the expense of a significant increase in the chance of experiencing severe economic impacts, from 5 to 6.9%. On the contrary, reducing the stocking rate by 20% reduces the chance of severe impacts from 5% to 3.7%, but also entails an increase in the probability of moderate losses and a significant drop in the probability of experiencing a favourable outcome.