I don’t normally post things that have nothing to do with triathlon and stuff. However, I read Warren Buffett’s letter to Berkshire Hathaway’s shareholders. I like his style of writing and that he takes responsibility for what he does.
Some bits did interest and surprise me though.
I am quite interested in what has been happening with the banks in the UK at the moment and the FSA’s reaction to it (and it is a shame it is a reaction). So I was interested to read that Warren Buffett says about derivatives and risk:
I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.
1. That he things that contracts are clearly mis-priced at inception. He doesn’t like Black-Scholes at times, which is fair enough when it isn’t being used within its range of assumptions. However, the example that he gives later is so obviously mispriced that it is just doesn’t make sense (unless he hasn’t quite told the whole story).
To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million.
If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.
2. The CEO must also be the Chief Risk Officer. I completely agree with this but it is a surprise to see him say it. It’s a shame that many CEO’s take a different view (or have no flair for the job).
I was also interested that he said one of the knock on consequences for all the government support of banks, etc could lead to an “onslaught of inflation”.
Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
I guess this means that when my fixed rate mortgage comes to an end in the summer, I want to get a looooong fixed rate period if the rates are as good as they are now.
