Options: Pricing, Payoffs and Who Sells Insurance

In the letter to Berkshire Hathaway's shareholders published in February 2009, Warren Buffett explained why his company had just reported a loss of about $5 billion on contracts that had not cost it a cent. Between 2004 and February 2008 Berkshire had sold put options on four stock indices, the S&P 500, the FTSE 100, the Euro Stoxx 50 and the Nikkei 225. There were 47 contracts in all. Each was European-style, so it could be exercised only on its final day; each was struck at the money, at the index level on the day it was sold; and each ran for 15 to 20 years. The buyers paid the whole premium up front: $4.9 billion at the exchange rates of the time, or $4.8 billion as the 2010 letter later put it. Berkshire would owe money only if an index stood below its strike on the expiry date, and then only the shortfall times the contract's notional amount.

By 31 December 2008 the indices had collapsed. The puts, with a notional value of $37.1 billion, had an intrinsic value of $10.8 billion and a fair value, by the Black–Scholes formula that accounting rules required, of $10.0 billion. Against the $4.9 billion of premiums, that was a mark-to-market loss of about $5.1 billion, and the year's pre-tax loss on the puts was about $5.0 billion (2008 letter and 10-K). The same Buffett had called derivatives "financial weapons of mass destruction" in the 2002 letter, and critics enjoyed the contradiction.

What happened next is why the case leads this chapter. Berkshire paid nothing in 2008, sold nothing and was never forced to. Most of the contracts required no collateral at all; Berkshire had posted about $550 million at the end of 2008, and the requirement peaked at $1.7 billion at the market's low early in 2009, against a securities portfolio of which, Buffett wrote, it was "less than 1%" (2008 and 2009 letters). Nobody could make Berkshire close a contract early: "it's only the price on the final day that counts". In 2009 the puts gained about $2.7 billion pre-tax as markets recovered. In 2010 a counterparty asked to unwind eight contracts, and Berkshire, which had received $647 million for them, paid $425 million to close them, a $222 million realised gain. The rest expired between 2018 and February 2023, and the 10-Ks called the settlement payments "relatively insignificant" and, later, "insignificant" (companion's profile of Berkshire Hathaway's derivatives, from the letters and 10-Ks). Berkshire held billions of dollars of premium for a decade or more, which Buffett called the main attraction. A naked short put, the position that ruins small option sellers, had survived the 2008 crash because of the terms on which it was written.