Thursday, May 8, 2008

Warren Buffett's Vega Games (BRK.A)

From Financial Crookery:

Between 2005 and 1Q 2008 Berkshire Hathaway sold index put options totaling approximately $40bn notional amount, receiving almost $5bn in premium. These at-the-money options were written over the S&P500 and three international indices (most likely the FTSE100, EuroStoxx50 and Japan's Nikkei or Topix - these are the most liquid indices for long dated options). The initial term of the options was either 15 or 20 years.

Before taking the other side of these trades, the investment bank counterparty would have formed a view on the following risks:

(1) What is the right price for long dated index volatility? Very long dated options have significant vega (sensitivity to implied volatility). One volatility point changes the model value of a 20 year S&P500 put by approximately 0.75% of the notional amount. By contrast, a 1% move in the index changes the model value by only 0.09% (9% delta).

There are takers for the other side of this volatility risk. Well, maybe not for 20 year duration, but at least out to 10 years or so. Constant buyers of long dated vega are retail investors, usually purchasing structured protected products - the simplest protected product is a zero coupon bond plus a long dated call option.

(2) Where is the 20 year forward for the S&P500
? Buying puts from Buffet means the bank is short the S&P500 forward. Unfortunately, selling calls to retail investors also leaves them short the forward. The market's demand for long dated forwards has always been so one-way that these forwards tend to trade rather high. Put another way, long dated options typically imply very low estimates of cash dividend growth. Presently, the 15 year S&P500 cash dividend growth implied from forward prices is negative 3%pa. Do we really think $30 of S&P500 dividends today (2.15% yield) will have dwindled to $16 in 2028? It's the same for international indices too....MORE