Wednesday, May 7, 2008

Berkshire Bets on Stock Market Increases

Warren Buffett’s company, Berkshire Hathaway, has sold put options on four stock indexes including the US S&P 500 (reported at the end of this Forbes article). These are essentially bets that the value of the stocks in the indexes will go up.

This is curious considering that Buffett was quoted in the rest of the article saying that stock market returns will be less than people think. This isn’t necessarily contradictory, though. The put option prices may have simply been too good for Berkshire to pass up.

In these transactions, Berkshire is providing insurance to stock investors. Berkshire has collected option premiums from the investors and has promised to cover these investors if their stock doesn’t rise to agreed upon prices at some point in the future (between 2019 and 2027).

Given Buffett’s lifetime investment record, it seems safe to assume that these put options were mispriced and that Berkshire collected large enough premiums that these transactions are expected to be profitable for Berkshire.

I wonder if this has anything to do with the fact that the best-known method of pricing options, Black-Scholes, has a serious flaw that gets worse the longer the duration of the option. This flaw is not serious for options that last for just a few months, but Black-Scholes gives wildly wrong answers for options lasting decades like the ones sold by Berkshire.

The cause of the flaw is the silly assumption that all investments have the same expected rate of return. I’d be willing to make a big bet that stocks will outperform government bonds over the next 50 years. Apparently, Berkshire has already made this bet.

5 comments:

  1. These puts are are special OTC puts that are European style (exercisable only on expiry which in these cases are many years from now).

    I think the Forbes author may be off in his understanding of writing puts - technically, writing a put means you are neutral to mildly bullish.

    Another way to think of it is to think of writing a put a way to get paid to wait for a stock to come down to the level you are willing to pay for it before you buy it, as the put holder will "put the stock to you" since they make money when the put trades in the money, and you are happy to buy it since you are buying it more cheaply than it was trading previously.

    For Buffett, he is basically pocketing the premium from selling the puts and if the put holders are in the money 11 to 19 years from now, I think he would be tremendously happy to be forced into buying these indices if they've been flat for 1 to 2 decades. And if the puts expire worthless, what does he care? He's already pocketed the premiums.

    It's an excellent play for those with conviction and/or those investing in indexed products with a neutral to mildly bullish outlook.

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  2. Preet:

    I think the Forbes author's explanation is consistent with yours. These long-term European style puts often have strike prices above the current market price to account for the expected rise in stock market indexes. So, Buffett is betting on stock market increases, even if the amount of the increase is small enough to qualify as a "neutral" outcome.

    The fact that Buffett may be willing to lose his bets is an interesting thought.

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  3. Writing in-the-money puts definitely makes more sense, more money up front and still allows Buffett to pick up bargains at expiry if the strike price extrapolates to an anemic return for the next decade(s) for the underlying indices. Plus he can invest the proceeds anytime between now and then (or ever) when he sniffs a bargain.

    Although, I still believe that if he were outright bullish and using derivatives he would use long calls over short in-the-money puts. Then again, I don't think he would use derivatives for speculation - I think he would just buy the stocks/indices being Warren Buffett.

    My take is that he is being paid to wait for an opportunity by writing the puts.

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  4. Preet:

    I think you're right that he plans to invest the premiums well, and that he is also getting paid to wait for his opportunity to buy stocks cheaply. A third possibility is that he believes that the puts were overpriced and were a bargain for the writer.

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  5. I just realized something: if Warren Buffett came to you and offered to sell you puts (or buy your company, or whatever), wouldn't you know he's lowballing his take on the intrinsic value? :)

    I mean, he's Warren Buffett - that's sort've his thing... :)

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