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Deflation hedges


kilroy04
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From the annual shareholders letter:

$100 billion notional amount in deflation hedges which still have 2.8 years to go and are now on our balance sheet at only $7 million.

 

Do you suppose this might yet come into play?  Anyone have access to data on this?

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US CPI Feb: 259

Deflation hedge strike: 231

Duration: 2.7 years

 

EU CPI: 105

Strike: 96

Duration: 2.2 years

 

Needs about 10% deflation to break-even. Have to see the #s for March, with O&G down so much, they might get a decent mark, but is there really a market to sell these securities? Maybe there's an early settlement clause?

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Thanks for posting that mcliu.  With severe recession (or more) and all the needed stimulus, it will be interesting to see what happens.  Even volatility could turn out to be significant with that notional amount.  There could be cds rhymes.  Based on the last 20 years, it would be somewhat unusual for FFH not to have some level of hedging.

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US CPI Feb: 259

Deflation hedge strike: 231

Duration: 2.7 years

 

EU CPI: 105

Strike: 96

Duration: 2.2 years

 

Needs about 10% deflation to break-even. Have to see the #s for March, with O&G down so much, they might get a decent mark, but is there really a market to sell these securities? Maybe there's an early settlement clause?

 

 

The interesting wild card is the shelter element of CPI.  It's a heavyweight in the index, and is it possible (likely?) that Covid and its associated recession could push US housing prices down considerably?  Otherwise, it's a bit tough to imagine a 10% haircut in the CPI.

 

 

SJ

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Even in 2009 CPI dropped by only 5%. It's possible, but unlikely in a fiat world. Maybe they'll get a bump in value though. We'll see March #s soon. Maybe it's structured so they can settle early, get a bit more $ out of it..

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Even in 2009 CPI dropped by only 5%. It's possible, but unlikely in a fiat world. Maybe they'll get a bump in value though. We'll see March #s soon. Maybe it's structured so they can settle early, get a bit more $ out of it..

 

I almost think we are more likely to have deflation now than 2008 - the disruption to cash flow and normal demand behaviour is greater. But it will be temporary. I will be stunned if the Fairfax deflation swaps are worth anything material.

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Even in 2009 CPI dropped by only 5%. It's possible, but unlikely in a fiat world. Maybe they'll get a bump in value though. We'll see March #s soon. Maybe it's structured so they can settle early, get a bit more $ out of it..

 

 

I have never worked on CPI, so I cannot say how the nuts and bolts of the calculation work.  But, I am very curious how governments will treat rent abatement for tenants who tell their landlord that they cannot or will not pay their full rent any time soon.  If they skip out on paying rent altogether, that's probably not considered to be a transaction for CPI purposes.  But, if my landlord agrees to drop my monthly rent from $1,000 to $750 until the end of 2020, is that captured as a price decrease?  Or is there some logic through which the government would still view the price as $1,000 for CPI purposes, and the $250 is just some sort of rebate that doesn't get captured?

 

The drastic decline in the price of petroleum would certainly be helpful for a lower CPI, but I'm not sure the weight is really that important.  But shelter is like one-third of the index...

 

I am not holding out much hope that the deflation derivatives will finish in the money.  Maybe the best hope is that the counter-party will want them off its books for some reason and would agree to a favourable cash settlement?

 

 

SJ

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  • 2 weeks later...
  • 3 weeks later...

US CPI out this morning for April, -0.8%, following a -0.4% for March.

 

https://data.bls.gov/timeseries/CUSR0000SA0?output_view=pct_1mth

 

Sitting at 256.4 right now. More details by category:

 

https://www.bls.gov/news.release/cpi.t01.htm

 

Many of the categories with large weights haven't budged, like Shelter, interestingly.

 

 

Thank you for posting that.  I knew the release was coming, but I probably would not have thought to look for it for a few more days. 

 

It's interesting that Residential rent bumped up a shade, as did imputed rent for an owned residence.  Does that make any sense to people?  Are people in your circle currently being served a rent increase by their landlord?  Are people in your circle currently seeing their house increase in market value (which ought to be the driver of the imputed rent)?  I would say that this is not happening in Canada right now, but maybe the US is different?

 

As McLiu noted earlier in the thread, the options are OTM at the moment, but would require a ~10% CPI decrease from Feb to become ITM.  If the counter-party is valuing this by model for the purposes of its financial reporting, this could begin to show up as a considerable liability on its Q3 financials if we see a few more months like this (the derivatives do not need to be ITM for modelled valuation to rapidly grow).  Depending on what's happening in the counter-party's business, perhaps they will want to get the liability off its books?

 

 

SJ

 

 

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Word around office space is starting to sound as if rents will be going down.  More people working from home - with a trend for this on a long term basis. Less office space need.  Don't know what will happen with residential rent.  I'm inclined to think that will trend down as well.  If you don't have a job or have less income, you move in with somebody else.  Vacancy created.  Who is going to rent that and at what price? This all seems to be deflationary pressure.  In the 2008 crisis, some of the cds gains could be seen before it showed up in the stock price.  I wonder if the same could occur here.

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One of the things that is happening in Canada is that the AirBnB market has collapsed, which is forcing a certain number of apartments and condos into long-term rentals.  Some of the AirBnB operators had rented an apartment and were simply re-renting it through AirBnB to make a profit.  Others had made the investment to put a down-payment on a condo (or multiple condos) and were using them for AirBnB short term rentals.  Clearly, that market will be dead for the foreseeable future, and there are a few people desperately seeking long-term tenants, which seems to be pushing rental rates a bit lower.  But, does it make a difference in the CPI?

 

Those hedges could become interesting if prices keep dropping for another 6 months or so...

 

 

SJ

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Might be a silly question, but what has to happen for them to get $100 billion?

 

Notional is actually $87bn as some contracts have expired. They pay out 1% of notional for every 1% that CPI is below the strike CPI level on the day of expiry. So for them to be worth $87bn, the price of everything in the CPI basket has to go to zero in each relevant territory. Not zero growth, zero absolute. If that happens, I’m going shopping.

 

Given average expiry is 2.9 years away, and they’re not currently in the money, you’ve got to have quite a rapid deflation for them to be worth $1bn at expiry, let alone $100bn.

 

That said, they can be sold to a greater fool, if one can be found who will pay a significant sum. And 2.9 is the average, so some of the contracts may be significantly longer. But I’d be very wary of pencilling in a best case valuation greater than a few hundred million.

 

 

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Might be a silly question, but what has to happen for them to get $100 billion?

 

Notional is actually $87bn as some contracts have expired. They pay out 1% of notional for every 1% that CPI is below the strike CPI level on the day of expiry. So for them to be worth $87bn, the price of everything in the CPI basket has to go to zero in each relevant territory. Not zero growth, zero absolute. If that happens, I’m going shopping.

 

Given average expiry is 2.9 years away, and they’re not currently in the money, you’ve got to have quite a rapid deflation for them to be worth $1bn at expiry, let alone $100bn.

 

That said, they can be sold to a greater fool, if one can be found who will pay a significant sum. And 2.9 is the average, so some of the contracts may be significantly longer. But I’d be very wary of pencilling in a best case valuation greater than a few hundred million.

 

good to know. Thanks!

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