Buffet Cleans Up on Derivatives Bet (via Fortune)

http://finance.fortune.cnn.com/2011/02/26/buffett-cleans-up-on-derivatives-bet/

Berkshire entered into the put contracts between 2004 and 2008. They came under fire from pundits after the post-Lehman Brothers financial collapse seemed to sharply raise the odds the contracts would prove costly to Berkshire.

The puts obliged Berkshire to pay its unnamed counterparty at the end of the contact period, in this case between 2021 and 2026, if certain equity indexes such as the S&P 500 declined over the course of the contract. In a worst case scenario, in which puts expired with the indexes at zero, Berkshire would have been obliged to pay its counterparties in this and similar contracts a total of $38 billion at expiration.

Of course, when Buffett wrote the puts the major stock indexes didn’t look all that likely to be lower in a decade or two, let alone go to zero. But the odds were looking distinctly less favorable for Berkshire around two years ago, when the S&P, for instance, traded as low as 666 — 58% below its 2007 peak.

But since then, U.S. stocks have posted their fastest double on record. With the economy growing again and every market commentator furiously beating the inflation drum, Berkshire’s unnamed counterparty apparently decided to cut its losses. It unwound its bet on falling stocks for the long term just three years after making it.

It is clear that Buffett views the results as a point in his favor in a long-running debate over the financial industry’s embrace of abstruse mathematical models. He has insisted he would continue to write derivatives contracts when it suits him in spite of the name-calling the practice inspired.

Buffett has said he would do so as long as he could see a good chance to make money on a given deal — and on the condition Berkshire gets paid upfront by its trading partner, eliminating any of the counterparty risk that nearly helped bring down the financial system in 2008.

“I believe each contract we own was mispriced at inception, sometimes dramatically so,” Buffett explained in his 2008 letter to Berkshire shareholders.

No small part of that mispricing, Buffett says, is driven by what he views as the false precision provided by models like Black-Scholes. It combines data including prices, contract duration, expected volatility, dividend and interest rates.

Buffett says academics, regulators and some market practitioners prize the formula — named after the economists Fischer Black and Myron Scholes, who popularized its use it in a 1973 paper — for its capacity to estimate a precise value for an option over a long span. That, alas, is a quality Buffett scoffs at.

Buffett says he cannot reliably come up with a pinpoint value for any given long-dated option, but adds that he would “rather be approximately right than precisely wrong.”

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