It was not so long ago when the Oracle of Omaha, Warren Buffett described derivatives as ‘financial weapons of mass destruction’ and warned against the extraordinarily high risks hidden in those instruments. He rightly said that those who are holding derivatives hardly understood the risks, a fact that was very evident during the recent credit crisis. That was when financial derivatives were not even a fraction as popular as they are now.
Having said that, we would have expected Buffett to stay clear of derivatives. But, contrary to popular wisdom, Buffett is not all that risk-averse – the stock portfolio of his company Berkshire Hathaway is very concentrated, for example. Unlike others, he is quite clear about the risk he is taking and that is the major reason for his superior and consistent performance. In other words, better risk awareness helps him prevent the huge losses others suffer once in a while.
Given that, markets were quite surprised when Berkshire declared a huge $1.6 billion loss on derivative contracts for the first quarter of this year. Most of these losses were on account of put options on the S&P 500 index. It seems Buffett was a bit too bullish on the markets! Credit default swap, which protects bond investors against default by issuers, contracts accounted for the rest of the losses.
Then again, these are non-cash losses and Buffett is unruffled. In his letter to shareholders he says he is not ‘bothered by these swings even though they could easily amount to $1bn or more in a quarter’. Since the end of the quarter, Berkshire is said to have recovered close to $0.5 billion of the non-cash losses as stock markets have recovered since April.
Clearly, derivatives, F&O, are something which has a huge amount of risk. And it requires lot of experience to understand and structure your positions so that the risk exposure gets reduced. One must not just jump in the F&O segment just by looking at the potential gain it can give.