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CFA

Bet against Buffett?

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It seems there is lots of confusion about Berkshire (NYSE:BRK.A, BRK.B) options (paper) loss in its Q1 earning report, especially among individual investors. First, let me quote Buffett’s take on those options in his recent annual shareholder letter (link to letters):

“The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk. Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.”

The Oracle has explained it very clearly. Since I was reading the related CFA material these days, I think those options are not standard options traded in Exchange. It appears someone likes to bet the S&P (and other stock indices) will go down in 15 or 20 years, and he/she is betting against Buffett in this case, as Berkshire has sold puts on those. Of course there is always possibility a stock index could go down in that period, but it is very unlikely, it would take a depression like 1930s to have a prolong bear market.

Related to recent market setback, it’s not surprising those puts options appreciated its value, and Berkshire booked paper loss because they sold the puts. It is conservative accounting from Berkshire side, and I wonder it’s hard to calculate the market value for those options because there is no market for it (non-standard options).

But seriously, if someone would like to bet stock index going down in 15, 20 years and bet a much smaller principle, I would like to sell you the puts 🙂

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