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The Science of Hitting
The Science of Hitting
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An Update on Berkshire's Equity Index Put Options

February 28, 2012 | About:

In the recently released Berkshire Hathaway (BKR.A)(NYSE:BRK.B) annual report for 2011, there’s a discussion on the company’s derivative contracts; I thought it might be instructive to take a look at the equity put derivatives, and talk about what they mean for those who may not be clear on their potential impact. Warren had this to say about them in the 2007 shareholder letter (with bold added for emphasis):

“The second category of contracts involves various put options we have sold on four stock indices [S&P 500, FTSE 100 in the UK, Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan]. These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk. Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.”

As discussed on page 44 of the 2011 report, the equity index put options have a notional value of just over $34 billion; this value is the undiscounted amount that Berkshire would need to pay at expiration (they are European style options, meaning they can only be exercised at expiration) if the four major indices discussed above were at zero (essentially, an apocalypse-type scenario; stock prices would probably be the least of your concerns in that situation).

On the other hand, if the indices ended an average 15% below the strike price agreed upon at inception, Berkshire would be on the hook for $5.1 billion; if they expire at or above the agreed upon strike prices (which were set from 2004-2009), Berkshire doesn’t have to pay out a penny.

As Warren noted above, it’s important to recognize that Berkshire already received the premium for these contracts; as such, they will be able to invest that capital for the benefit of Berkshire’s shareholders until expiration, which ranges from 2018 to 2026; in aggregate, the contracts have a remaining average life of approximately nine years.

At year-end, the aggregate intrinsic value (the amount Berkshire would have had to pay) was approximately $6.2 billion; Berkshire recorded pre-tax losses of $1.8 billion on the put option contracts in 2011 due to declines in three of the indices and lower interest rate inputs (which affected fair value as calculated with the Black-Scholes formula). This compares to a gain of $172 million and $2.7 billion on the contracts in 2010 and 2009, respectively.

It’s important to understand that those gains/losses are largely based upon the short-term movements in the four indices and changes in the assumptions that are put into the model, including expected volatility, dividend rates and interest rates. As Warren discussed above, this will cause short-term fluctuations even when intrinsic value is relatively unchanged; for shareholders, it would be intelligent to follow Warren’s example and not be bothered by such swings.

Warren had this to say about the contracts in the 2011 letter:

Charlie and I continue to believe that our equity-put positions will produce a significant profit, considering both the $4.2 billion of float we will have held for more than fifteen years and the $222 million profit we’ve already realized on contracts that we repurchased [at the counterparty’s request in the fourth quarter of 2010].”

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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