![]() In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. ![]() As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. This substitution can bring on large-scale mischief. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But the parties to derivatives also have enormous incentives to cheat in accounting for them. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.Įrrors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. Overstated earningsĪnother commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. But most strategies of that kind leave you with residual liability. True, there are methods by which the risk can be laid off with others. ![]() In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). We failed in our attempts to sell the operation, however, and are now terminating it.īut closing down a derivatives business is easier said than done. When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. No problem – at a price, you will easily find an obliging counterparty. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.Įssentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. An excerpt for that shareholder letter:Ĭharlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. One of my favorite gems is in the 2002 shareholder letter in which Buffett describes derivatives as ‘financial weapons of mass destruction’, carrying dangers that, while now latent, are potentially lethal. ![]() Each contains hidden gems of value investing wisdom. ![]() One of our favorite investors at The Acquirer’s Multiple is Warren Buffett.Īs a value investor, one of the most important free investing resources is Buffett’s Berkshire Hathaway shareholder letters. ![]()
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