Warren Buffett sold a number of large, long-dated put options against various stock indices between 2004 and 2008, and while those puts are definitely liabilities, there seems to be a big disagreement about how much of a liability they should be reported as.
Options normally priced with Black-Scholes
Options are normally priced using the Black-Scholes equation, which takes a number of factors into account, including the asset’s underlying price, interest rate risk, and volatility. Dan McCrum, writing for FT’s Alphaville, does a great job explaining the nitty-gritty, but even without getting into how Black-Scholes works (or doesn’t, not everyone agrees with it or thinks it should be used it for valuation), the fact is that global markets tanked, interest rates fell, and volatility went up. All three of those factors should have contributed to major losses, so it’s strange that Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) reports the liability at just double the premium ($10 billion on $4.9 billion in premiums). Most people would have expected the value to be much higher.
Except Buffett doesn’t trust Black Scholes
While it’s not clear exactly how Buffett valued the long-term put options, it is clear that he doesn’t put much faith Black-Scholes.
“Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options. We set out one absurd example in these pages two years ago. More tangibly, we put our money where our mouth was by entering into our equity put contracts. By doing so, we implicitly asserted that the Black-Scholes calculations used by our counterparties or their customers were faulty,” he wrote in a Berkshire Hathaway letter from 2010. “We continue, nevertheless, to use that formula in presenting our financial statements.”
If Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) is still using Black-Scholes for options valuation, then the $10 billion in put option liabilities is hard to justify, but if the company has changed its valuation methods without telling anyone, that would also seem bizarre. Most likely people wouldn’t mind if he gave a detailed explanation of how he arrived at the $10 billion figure, since they could judge the soundness of his assumptions and calculate what they think the options should be valued at independently, but until some more details about how Buffett arrived at that figure we will have to continue to wonder.