Question about Buffett's Puts

Discussion in 'Options' started by Wolfgang1756, Nov 7, 2009.

  1. I have read that Warren Buffett wrote a lot of uncovered Puts on all the world's major stock indexes with an expiration of like 15 years or so. I thought the longest Call/Puts were like 1-2 years! 15 years???

    Is there a way to find out exactly which indexes and strikes? And the premium he got?

    I am just curious what Implied Volatility he got???

    Also I read today on Bloomberg that he is also short Credit Defualt Swaps. Things which contributed to the collapse last year!

    So which companies bonds did he sell protection for? I hope not Lehman :D

    Where can I find all this info?

  2. If he did short those puts they are not listed products, it would be all OTC stuff so you wont be able to find out.

    The credit default market is also not a listed market so again its private party info
  3. CET


  4. ptrjon


    I would sell thse all day on the american indices if someone let me. The only way these options will have any value is if the stock market goes down an annualized 3%* every year over the next 20 years. (* approx. Inflation adjusted).
  5. Actually they can easily blow up in your face in a major sell off which does not have to happen over time. The margin to carry those short puts would go through the roof and they would be tough to hold.
  6. dcvtss


    From an reuters article from earlier this year -


    * Buffett has entered into 251 derivatives contracts, most
    of which are essentially bets on the long-term direction of
    stocks and junk bonds. He has said these contracts differ from
    other derivatives he has called "financial weapons of mass
    destruction" in part because of the billions of dollars of
    premiums he collects upfront from counterparties. Berkshire has
    four major types of contracts:

    -- Berkshire has equity index "put" options tied to where
    the Standard & Poor's 500, Britain's FTSE 100, Europe's Euro
    Stoxx 50 and Japan's Nikkei 225 trade between September 2019
    and January 2028. At year end, Berkshire had a $10.02 billion
    paper liability on these contracts and said it could in theory
    owe $37.13 billion if the indexes all went to zero.

    -- Berkshire has contracts tied to credit losses in
    higher-risk "junk" bonds between September 2009 and December
    2013. At year end, Berkshire had a $3.03 billion paper
    liability on the contracts and said it could in theory owe up
    to $7.89 billion.

    -- Berkshire wrote credit default swaps on $3.9 billion
    of contracts covering 42 companies. At year end, Berkshire had
    a $105 million liability.

    -- Berkshire entered into tax-exempt bond insurance
    contracts structured as derivatives. At year end, Berkshire had
    a $958 million liability and $18.36 billion of potential
    losses. Buffett said "we feel good" about the underlying bonds,
    which are largely secured by states' taxing and borrowing

    Google is an amazing thing.
  7. ptrjon


    yeah, that's included in the "if someone let me" part of my last post.

    Buffett's contracts are European, meaning there is no early exercize allowed. Also, he is not required to hold any money in escrow for this- no collateral, no nothing.

    It's amazing what you can do when you're worth over 60 billion and your company has billions of dollars in cash.
  8. We have added modestly to the “equity put” portfolio I described in last year’s report. Some of our
    contracts come due in 15 years, others in 20. We must make a payment to our counterparty at
    maturity if the reference index to which the put is tied is then below what it was at the inception of
    the contract. Neither party can elect to settle early; it’s only the price on the final day that counts.
    To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at,
    say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million.
    If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In
    the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to
    $150 million – that we would be free to invest as we wish.
    Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major
    indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the
    Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24,
    2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have
    paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black-
    Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change
    on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9
    billion in premiums we have received – means that we have so far reported a mark-to-market loss
    of $5.1 billion from these contracts.
    We endorse mark-to-market accounting. I will explain later, however, why I believe the Black-
    Scholes formula, even though it is the standard for establishing the dollar liability for options,
    produces strange results when the long-term variety are being valued.
    One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion
    we have at risk, all stocks in all four indices would have to go to zero on their various termination
    dates. If, however – as an example – all indices fell 25% from their value at the inception of each
    contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion,
    payable between 2019 and 2028. Between the inception of the contract and those dates, we would
    have held the $4.9 billion premium and earned investment income on it.


    The Black-Scholes formula has approached the status of holy writ in finance, and we use it when
    valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s
    maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.
    If the formula is applied to extended time periods, however, it can produce absurd results. In fairness,
    Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring
    whatever caveats the two men attached when they first unveiled the formula.
    It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1
    billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied
    volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and
    dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.
    To judge the rationality of that premium, we need to assess whether the S&P will be valued a century
    from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only
    2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher.
    Far more important, however, is that one hundred years of retained earnings will hugely increase the value of
    most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about
    175-fold, mainly because of this retained-earnings factor.
    Considering everything, I believe the probability of a decline in the index over a one-hundred-year
    period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one
    occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5
    million ($1 billion X 1% X 50%).
    But if we had received our theoretical premium of $2.5 million up front, we would have only had to
    invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have
    been profit. Would you like to borrow money for 100 years at a 0.7% rate?
    Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay
    nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that
    is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my
    assumptions are crazy or the formula is inappropriate.

    The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion
    of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around
    in some past period of days, months or years. This metric is simply irrelevant in estimating the probability-
    weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every
    day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing
    quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm
    a century from now.)
    Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options,
    its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-
    Scholes formula now place on our long-term put options overstate our liability, though the overstatement will
    diminish as the contracts approach maturity.
    Even so, we will continue to use Black-Scholes when we are estimating our financial-statement
    liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might
    offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted
    their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club
    of optimists is one that Charlie and I have no desire to join.

    -Buffett's annual letter
  9. dmo


    Very interesting Matador, thanks for posting that.

    Prior to Black Scholes, attempts at option pricing models all assumed the need for a "risk premium" - an input that estimated where prices would be at expiration. In other words, should the bias be on the upside or the downside? Nobody ever did a very good job of quantifying that, which is why no conclusive, "consensus" option pricing model existed.

    Black, Scholes and Merton's great contribution was demonstrating a mathematical justification for eliminating the risk premium, simply assuming prices are a random walk, and using a straight lognormal probability distribution.

    Basically, Buffett is going back to the pre-BSM "risk premium" concept, and saying that assuming a random distribution for stock prices over a period of many years is a bad assumption that doesn't correspond with reality. He's saying that a realistic pricing model would have to assume a long-term upside bias in stocks and since the BS model doesn't, he's taking advantage of what he sees as the BSM's major flaw.
  10. IF you are short put or call you need to be prepared to take delivery or deliver equity at any moment. It usually does not happen till expiration.

    But Put's are a special case since assignment is more likely than calls before expiration. (investor needs to exercise early long put contracts to use the cash received in a better way and avoid opportunity cost etc..)

    So if you aint got the capital to sell insurance, you should not sell insurance.

    You need to treat options as insurance and if you are going to be an insurance provider you need to think like an actuary and you need to treat your business as a real insurance company would.

    ie: having capital to pay off claims, having a diversified pool of insurance contracts etc..

    If you look at it as a way to leverage and gamble you will be living in the poorhouse quicker than you would imagine.

    BTW: Black Scholes etc.. is just a tool. Like a ruler to measure or a barometer. Not a predictor of future options prices.

    I do use the models myself but I also have proprietary tools to work out P/L expectations and risk etc..

    I treat the Business as any proper insurance company would.
    #10     Nov 7, 2009