Buffett Ignores Changing Volatility In Put Contracts Valuations

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Buffett Ignores Changing Volatility In Put Contracts Valuations
By Mark Hirschey (Work of Mark Hirschey) [CC BY-SA 2.0], via Wikimedia Commons

Warren Buffett’s decision to write $50 billion worth of European-style put contracts against major stock indices between 2004 and 2008 for $4.9 billion in premiums has previously drawn attention for the strange way they seem to have been priced, but now it seems that Berkshire Hathaway has stood by pre-crisis volatility predictions that no longer make much sense, which make the company’s exposure look smaller than it probably is.

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Berkshire Hathaway stuck by initial volatility estimates

“Berkshire has opted for a peculiar way of dealing with volatility. The firm is using the Black-Scholes volatility parameter as a static forecast and has stoically stuck by such prediction even in the face of some of the most wildly swinging markets ever contemplated,” writes Pablo Triana in the latest paper analyzing Buffett’s put contracts, reports Dan McCrum at The Financial Times.

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In other words, Berkshire estimated the future implied volatility for the put contracts when it wrote them, in some cases a decade ago, and has decided not to update those numbers in light of more recent events – like the meltdown of the world financial system.

To be fair, Buffett has always said that he doesn’t put any stock in the Black-Scholes asset pricing model that is used almost uniformly among derivatives traders, so it’s not surprising that he doesn’t spend a lot of time fine-tuning valuations based on that model. But keeping the volatility low did have at least a short term benefit for Berkshire Hathaway.

“The odd thing about that valuation process is that it only spat out a liability of $10bn at the height of the financial crisis, just twice what Berkshire had received in premium as markets lost their mind,” writes McCrum.

Lack of updates may show just how little Buffett cares about Black-Scholes

If Berkshire Hathaway had updated volatility with higher numbers then the company would have reported losses instead of slim gains in 4Q2008 and lower profits in 2008 as a whole. But Buffett has always told investors in his company not to focus on the short-term ups and downs, so it would be strange if the decision to stick with his initial assessments was an attempt to manage earnings.

It’s pretty clear from public statements that Buffett doesn’t base his investment decisions on Black-Scholes valuations, so it seems more likely that he wasn’t much concerned with what the equation said about the value of the contracts.

Check out the full report below

Buffett-and-Black-Scholes-what-does-volatility-mean-final

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Michael has a Bachelor's Degree in mathematics and physics from Boston University and Master's Degree in physics from University of California, San Diego. He has worked as an editor and writer for several magazines. Prior to his career in journalism, Michael Worked in the Peace Corps teaching math and science in South Africa.
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1 COMMENT

  1. Probably not an article worth writing…most people know Warren Buffett is unlikely to put much more emphasis (or effort) in managing his derivatives portfolio than necessary.

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