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Grass Hopper
Grass Hopper
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Prem Watsa on Fairfax's CPI-linked derivative contracts

March 09, 2014 | About:

In this world of large unintended consequences, one of which may well be deflation, we have added to our position in CPI – linked derivative contracts, as shown below:

As you can see from the table, in 2013 we increased our nominal exposure to these contracts by 71.3% for an additional cost of only 20.2%. As of December 31, 2013, these contracts were carried on our books at $131.7 million, a 75.9% decline from our cost. The remaining term on these contracts is 7.5 years. Like in 2012, Brian Bradstreet has refreshed some of these older contracts by exchanging them for newer, more current indexed contracts – thus effectively increasing the weighted average strike price of the index (CPI) on the U.S. contracts to 230.43 from 223.98 – only 1.1% away from the U.S. CPI index at the end of 2013!

The table below provides you more details on our CPI-linked derivative contracts as of December 31, 2013:

As we did last year, we remind you that cumulative deflation in the U.S. in the 1930s and Japan in the ten years ending 2012 was approximately 14%. It is amazing to note that including 2013, Japan has suffered deflation in most of the last 19 years – beginning about five years after the Nikkei index and real estate values peaked....

In the last four years, we have had significant losses, mostly unrealized, from our hedging program and from our CPI-linked derivative contracts, as shown below:

These losses are significant but they are mostly unrealized, and we expect both of them to reverse when the ‘‘grand disconnect’’ disappears – perhaps sooner than you think! In a declining market, like 2008 – 2009, we expect our common stock portfolio to come down much less than the indices, thus reversing most of the net losses resulting from our hedges. As I said last year, we are focused on protecting our company on the downside against permanent capital loss from the many potential unintended consequences that abound in the world economy.

From Fairfax Financial 2013 Chairman’s Letters to Shareholders

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