The Warren Buffett derivative trading mystery grows, as Bloomberg’s Matt Levine takes aim at FT Alphaville series written by Dan McCrum and raises questions.

Readers will recall that in Wednesday’s ValueWalk we reported on Warren Buffett utilizing exotic derivatives in his portfolio management. In particular, he sold a long-dated put option on three stock indices in what was known as “Worst of Basket Put Option.” This is an exotic option that pays only on one of three stock indices, the one that has the best payout structure. Levine points out in his article, “this is some pretty racy stuff for a guy who famously went around saying that derivatives are “time bombs .”

## “Mildly titillated” by negative cross gamma

Levine humorously begins the article by noting how he was “mildly titillated” by McCrum’s use of the term “negative cross gamma” to describe sensitivity to the option contract’s movement being benign because one component is in the money while the other two legs of the exotic option are out of the money. After brief checking in the algorithmic trading community – option market makers, high frequency trading risk managers, managed futures CTAs – negative cross gamma is something not often utilized because it speaks to an option feature so exotic pricing it is considered a fragile black swan model — exactly the type of derivative Buffett had previously derided.

## 20-year prognostication a stretch even for Buffett

Not only do the three legs of the option play make the math wobbly, but the real issue is the time horizon. Buffett sold a 20 year put on the stock market. How can anyone place a valuation on a stock market put going 20 years into the future? Another quantitative HFT trader noted that, based on logical projections of government spending and revenue patterns, a government debt crisis is easier to build probability tables around than would be a 20 year put option on three different indices.

But when you factor in Buffett’s government backstop such an insurance gamble begins to become logical. Buffett can afford to write insurance on catastrophic market events because if such events were to occur, he will have the benefit of the U.S. taxpayer to backstop his risk.

## Transaction type: market maker or taker?

In the article Levine continues to make interesting points, including analysis regarding the nature of the transaction. “There are two ways that a bank could find itself doing a trade: By paying for it, or by being paid for it,” Levine points out in the article. “In the first type of trade, the bank is *looking to buy something*. Here, that something would be protection. The bank actively wants to hedge a risk or whatever, and goes to a deep-pocketed highly rated counterparty and asks it to write the bank some insurance. The fact that Lehman charged Buffett $16.5 million for this trade means that it’s a customer-facilitation trade.”

## Derivatives profit calculation based on notional value

The point where Levine moves to determining the calculation of profit percentage might also be cause for examination. “How nice is this profit?” Levine asks. “It’s $16.5 million on a $1 billion notional, or 1.65 percent of notional. Compare Goldman’s profit of 2.5 to 6.7 percent of notional on the options it sold to Libya, which Libya is mad about. And those options were shorter-dated (3 years) and pretty vanilla; the Buffett ones run for decades and seem to have been a bit more exotic. If you amortize the $16.5 million over 20 years of (uncollateralized!) derivative exposure, it’s only like 8 basis points a year, which is very skinny.”

In managed futures, an investment category based on derivatives, all profit calculations are based on the nominal amount, not the notional. In fact, this is the most common method of calculating profits in the majority of regulated derivatives transactions where the counterparty is required to post a margin deposit. And here is the key difference. Buffett’s trades were not of the regulated type nor were counterparties required to post a margin deposit. A key difference that points to the key risk.** **