Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Op-Ed: Warren Buffett Still Master of His Domain

By

Huge derivative exposure? What huge derivative exposure?

PrintPRINT
Editor's Note: Todd Sullivan can be found online at Value Plays.

I just can't understand why people are so up in arms over Berkshire Hathaway's (BRK-A) recent Annual Letter. Here's it's much-talked-about discussion of "equity put options":

"Our contracts fall into 4 major categories. With apologies to those who aren't fascinated by financial instruments, I'll explain them in excruciating detail.

"We have added modestly to the "equity put" portfolio I described in last year's report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counter-party at maturity if the reference index to which the put is tied is then below what it was at the inception of the contract. Neither party can elect to settle early; it's only the price on the final day that counts.

"To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 -- down 10% -- on the day of maturity, we would pay $100 million. If it's above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to 0. In the meantime, the sale of the put would have delivered us a premium -- perhaps $100 million to $150 million -- that we'd be free to invest as we wish.

"Our put contracts total $37.1 billion (at current exchange rates) and are spread among 4 major indices: the S&P 500 in the U.S., the FTSE 100 in the UK, the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We've received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black-Scholes valuation methods to record a year-end liability of $10 billion, an amount that will change on every reporting date. The 2 financial items -- this estimated loss of $10 billion minus the $4.9 billion in premiums we've received -- means that we've so far reported a mark-to-market loss of $5.1 billion from these contracts.

"We endorse mark-to-market accounting. I'll explain later, however, why I believe the Black-Scholes formula, even though it's the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued.

"One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all 4 indices would have to go to 0 on their various termination dates. If, however -- as an example -- all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we'd have held the $4.9 billion premium and earned investment income on it.

So the $37.1 billion number we hear about as Berkshire's "exposure" is bunk. Berkshire is exposed to that number if the value of European, US and Japanese stock markets go to 0. A true doomsday scenario that, should it happen, essentially means the end of all economic activity as we know it.
< Previous
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE