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.