WARREN BUFFETS LOVE HATE RELATIONSHIP WITH DERIVATIVES

IFMG Section B, Group 10

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Sadia Khan (12FN-108) Aritra Samajpati (12FN-027)

Abhinav Kumar Singh ( 12FN-003)

Patel Kinjal Mahendra (12FN-090) Nirupama Kaur( 12FN-084)

Background
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely considered the most successful investor of the 20th century. Buffett is the chairman, CEO and largest shareholder of Berkshire Hathaway. The case presents excerpts from his 2002 letter to shareholders where he holds nothing back in vilifying derivatives and contrasts it with his 2007 letter to the shareholders where he describes how Berkshire Hathway invested in 94 derivative contracts.

Source: Bank for international Settlements

Q1) In his 2002 letter to shareholders, what does Warren Buffett seem to fear most about financial derivatives?

Warren Buffet , in his 2002 letter to shareholders considers derivative contracts to be equivalents of time bombs waiting to explode. He fears so for many reasons that are well highlighted in the case. In his words,
The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

The value of derivative contracts depends on the credit-worthiness of the counterparties unless the contract is collaterized.

Derivatives are easy to enter but difficult to exit. The parties to the derivatives may have incentive to cheat by falsifying their reported earnings by overstating them. Derivatives can aggravate trouble that a corporation has run into due to unrelated reasons as many derivative contracts require a company suffering a credit downgrade to immediately provide collateral to counterparties. These investments often invite a terrific deal of credit which may in turn lead to fall of an institution or corporate meltdown like the plunge of the hedge fund of Long-Term Capital Management in 1998.

Q2) In his 2007 letter to shareholders, what does Warren Buffett admit that he and Charlie had done?

In his 20007 letter to the shareholders, Warren Buffet described how Berkshire Hathway had 94 derivative contracts of two types, credit default swaps and put options on stock indices. He admitted that in both the cases they have no counterparty risk as they hold the money. Buffet also admitted that they sold the company holdings for four billion dollars and that of the ninety four derivative contracts, fifty four that he managed were due to expire at various times from 2009 to 2013.

He admits that he and Charlie believe that their intrinsic position has changed but they have no reason to worry as they see an increase in the future net worth to be more substantial that the increased short term volatility in reported earnings. In his words,
our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these

Q3) Do you think there is an underlying consistency in his viewpoint on the proper use of derivatives?

We also think that there is an underlying consistency in his viewpoint on the proper use of derivatives. With the range of derivatives only limited by the imagination of man and the dependence of value of the derivative contract on the credit worthiness of the counterparty, it is justified that derivatives should be used properly and they should be guaranteed. There is another reason which prompts us to agree to his viewpoint, the concept of marking to market implies that before the settlement of a contract, the parties record their profits and losses and in the process, money is not actually exchanged. This leads to overstatement of the earnings and these has lead to some huge scale frauds

These contracts make it difficult to assess the financial condition of firms that are heavily involved in derivative contracts. Marking errors in the derivative business are not symmetrical, the have mostly favored the trader or the CEO. Hence these instruments must be used properly.

Thank You !