Buffet's view on Derivative contracts

Derivative contracts

Finally, you should expect large swings in the carrying value of these contracts, items that can affect our reported quarterly earnings in a huge way but that do not affect our cash or investment holdings. That thought certainly fit 2009’s circumstances. Here are the pre-tax quarterly gains and losses from derivatives valuations that were part of our reported earnings last year:

Quarter    $ Gain (Loss) in Billions
1    (1.517)
2    2.357
3    1.732
4    1.052

As we’ve explained, these wild swings neither cheer nor bother Charlie and me. When we report to
you, we will continue to separate out these figures (as we do realized investment gains and losses) so that you can more clearly view the earnings of our operating businesses. We are delighted that we hold the derivatives contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn further investment income over the life of our contracts.

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to
invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998.

The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead

• to leverage and/or 
• counterparty risk that is extreme. 

At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.


http://www.berkshirehathaway.com/letters/2009ltr.pdf



Comment:

For those tracking their portfolio, the large swings in their portfolio values should be expected and should not excite them unduly.  For the long term investor, focusing on the operations of the businesses of the stocks in the portfolio is more important.  As was mentioned, the large swings do not affect his cash position or his investment holdings.