Warren Buffet on Black Scholes.

J

just21

http://online.wsj.com/public/resources/documents/WSJ-20090228-berkshireletter.pdf

see page 20 of Chairman's letter. Discuss here.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion
of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around
in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted
range of values of American business 100 years from now. (Imagine, if you will, getting a quote every
day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing
quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm
a century from now.)
Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options,
its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-
Scholes formula now place on our long-term put options overstate our liability, though the overstatement will
diminish as the contracts approach maturity.
 
Quote from just21:

http://online.wsj.com/public/resources/documents/WSJ-20090228-berkshireletter.pdf

see page 20 of Chairman's letter. Discuss here.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion
of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around
in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted
range of values of American business 100 years from now. (
More...

Were his put sales set for 100 years from now? I don't think so. I think it's obvious that short term volatility needs to be and is priced into options and that's what is making the put sales show a high liability against him.

I really don't follow Buffet/Berkshire that much, but I would also mention that when they sold those puts, they most likely got more because of higher IV then say if they had sold the puts years ago as well. It just sounds to me like someone who wants things both ways - alot of value when selling, but not having the high value calculated against him.

I think BS is working fine in this case and overall.

JJacksET4
 
Buffet is really complaining that he does not have a good value to use for the volatility. Neither historical nor implied volatility for the next 6 months are good proxies for an IV for 100 years on something marked to market.
 
Quote from just21:
the valuations that the Black-
Scholes formula now place on our long-term put options overstate our liability, though the overstatement will
diminish as the contracts approach maturity.
More...
Has Berkshire had to post anything against these puts? Other than its still AAA rated balance sheet (full faith and credit)? If it has not had to post, and given CDS prices on Berkshire debt, a properly implemented version of BSM has Berkshire in profit marked-to-market on the short puts. The value of the pure option aspect has increased, but the value of Berkshire's promise to pay on them has decreased even more.
 
Perhaps BRK isnt at risk of losing big on their puts but there is a risk they lose triple A(which could be worth a lot). Does anyone know if the rating agencies pay attention to the GAAP marks from the puts or they do buffett type thinking when valuing the contracts?
 
Hmmm. There are two time frames touched on:

1) 100 years

and

2) talking to your neighbor every day

It seems to me that there is a lot of ground inbetween, for which IV might serve as a useful estimate of expectations.

If I were a long term investor, I would not give a rat's ass what a stock does in 100 years, or what it does tomorrow. But the stuff in between could be very important.
 
Quote from Cutten:

He won't have to worry about Black Scholes if the value of the put becomes mostly intrinsic later this year.
More...

Cutten,

You cut to the chase and made a great point there. I think it is often overlooked by options traders. For example, sometimes I hear people say things like "If I buy an ATM call and the stock soars, the IV will fall, and I could lose, right?". IV is important of course, but Intrinsic value will almost always overwhelm time value when a stock has a large movement into the money.

As time becomes less and less and intrinsic becomes more and more, whatever formula is used matters less.

JJacksET4
 
Quote from just21:

http://online.wsj.com/public/resources/documents/WSJ-20090228-berkshireletter.pdf

see page 20 of Chairman's letter. Discuss here.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion
of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around
in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted
range of values of American business 100 years from now. (Imagine, if you will, getting a quote every
day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing
quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm
a century from now.)
Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options,
its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black-
Scholes formula now place on our long-term put options overstate our liability, though the overstatement will
diminish as the contracts approach maturity.
More...

I'm taken aback by Buffett's narrow understanding of options. How ironic that the instruments Buffett called "Financial weapons of mass destruction" could prove to be his own undoing. Like straight out of a Greek tragedy where the hero unknowingly (but accurately) predicts his own demise.
 
Quote from dmo:

I'm taken aback by Buffett's narrow understanding of options. How ironic that the instruments Buffett called "Financial weapons of mass destruction" could prove to be his own undoing. Like straight out of a Greek tragedy where the hero unknowingly (but accurately) predicts his own demise.
More...

Second that. I am amazed by Buffet's lack of knowledge and his low general education level. He reminds me of an inquisition ideologist with a very narrow vision.
 
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