Buffett's big bet

The put options are exercisable only at maturity, thus a catastrophic event in the interim would not force a payoff, and Berkshire never has to post collateral. The long time horizon makes it unlikely he will have to pay while boosting the time value of the $4.5bn premium. The spike in Berkshire's credit default swaps may be linked to these contracts, however, since counterparties, lacking collateral, may be forced to buy them to cover counterparty risk.

Still, timing is everything. These puts would have fetched far more with today's higher implied volatility as well as having a smaller chance of being paid out due to the lower starting market valuation. Crestmont Research points out that there have been 10 different 15-year periods since 1900 when the S&P 500 was lower at the end. But of these, six followed the Great Depression and three would have seen a lower payout on the puts than the future value of the premium.

Buffett has shrewdly traded short-term volatility for long-term returns but his odds were hurt by high starting valuations and the possibility of deflation down the line. He is unlikely to lose but, in this case, he acted more like a good actuary than a great value investor.

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