Buffett Optimistic about the Market: Sells Put Option Insurance

Submitted by Marco on 13 April, 2006 - 12:52

Buffet is optimistic that the markets will not crash in the near future & sells financial instrument like insurance: Put options

Warren Buffet, the world's second richest person and arguably the best value investor has sold a form of insurance on the markets which would protect buyers from any falls in price of the underlying commodity (Something like a put option). This means that Buffett is placing his bets - actually a $US14 billion (AUD$19.6 billion) bet that global markets will not go into freefall. Buffet made this investment as a result of struggling to find suitable aquisitions large enough to boost Berkshire Hathaway's returns.

According to a US Securities and Exchange Commission filing, Berkshire has sold this form of insurance to buyers who want to hedge themselves against a drop in "four major equity indices". So instead of buying stocks, Buffet is betting that the markets won't tumble to cause Berkshire Hathaway to pay out insurance claims on a drop of any of the indices he has issued these put option insurance type financial instruments. Buffet had to turn to these "unconventional" investments like, oil derivatives, silver and zero-coupon bonds due to a shortage of "undervalued" companies.

David Winters of Wintergreen Advisers in Mountain Lakes, New Jersey says that "They figured out a very interesting strategy that basically nobody else can do because of their size and long-duration capital, Buffett and [Charlie] Munger have made the ultimate contrarian play here. They take a premium in today and they're willing to buy securities if markets really plunge." According to the SEC finding, Berkshire Hathaway their maximum exposure was about $US14 billion at the end of last year. So these put option insurance-like derivatives they sell to people wishing to insure their position pay up an insurance premium that Berkshire Hathaway collects. In any event that the price of the equity falls, Berkshire Hathaway is liable to pay up to the value of the insuace contract - the put option price. In the filing it also stated that a 30 per cent decline in each of the indices last year would have led to a $US900 million pretax loss for the company. Hoever it did not disclose which stock indices were covered in these contracts, how they're structured, who bought them or how much Berkshire was paid.