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CPI Derivative Contracts Question


Guest zgrendi
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Guest zgrendi

So Fairfax has CPI Derivative Contracts for the EU notionally worth 27.2 billion as per the 1st quarter report.  They're in euros.  I really like these because it seems like the mix of austerity and lack of growth is a recipe for deflation.  But what happens if the Euro falls apart?  I know its a long shot but its not out of the question.  Who wins if that happens? 

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So Fairfax has CPI Derivative Contracts for the EU notionally worth 27.2 billion as per the 1st quarter report.  They're in euros.  I really like these because it seems like the mix of austerity and lack of growth is a recipe for deflation.  But what happens if the Euro falls apart?  I know its a long shot but its not out of the question.  Who wins if that happens?

 

The question was asked at the AGM. Brian Bradstreet answered the question, and he said it was a good question. It is a real risk with the CPI derivatives, but he said there will be some work out solution if the Euro dissolves itself. If I remember correctly he said there may be a weighted measurement of the CPI across various countries. He mentioned that the TIPS market in the Euro is big as well and they'll need a solution if the Euro dismantles.

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Do they start to lose significant amounts of money of heavy inflation starts happening (as suggested by other camps)?  It seems like there isn't protection from that outcome.

 

From what I understand, no. They are one direction. If there is high inflation, the contracts expire worthless. One of the annuals or letter's explains how they work, if I remember correctly.

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I was a little confused about the contracts also. I had thought they were options because the financial reports mention option pricing models and volatility pricing inputs. But on the conference call yesterday Prem mentioned "inflation swaps" which makes me wonder if they have a mix of swaps and options. Hopefully this was just a slip because to me the obvious preference would be for (cheap) options so additional losses don't accrue in the case of inflation.

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If you see big inflation, the CPI contract is not a major concern because it's cost is fixed, so the downside is limited. But, it's another story for the fixed income portfolio.

 

We are hedged against a deflation scenario, but not for a high inflation one.

 

It's like the Noa story. We have a boat in case it rains...but if it's shiny and hot, we'll be thirsty.

 

Cheers!

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