Nothing to see here, move right along February 6, 2014 at 9:40 pm
Dear me, can’t a billionaire write a bunch of long-dated exotic derivatives without those pesky kids sticking their noses in? Warren is getting a rough ride from Dan McCrum repeatedly, and today from Matt Levine, and he doesn’t quite deserve it. Here’s why.
- First, level three assets are not necessarily toxic. They can just be hard to value precisely. Even if Warren had just sold 20 year plain vanilla equity index puts, they would be level three, as there is no ready market in twenty year implied vol (although you can make a pretty decent guess from where the ten year is).
- Warren is naked short. Black Scholes and related approaches are valuation techniques which work if you are hedging (and you can indeed replicate the derivative by following your model’s hedge ratios). There is actually quite a good theoretical argument (if not an accounting standards one) for him not to mark to market – an argument that would be more convincing if he has written an insurance policy that is then transformed into a derivative via an SPV. We don’t know that he hasn’t done this. But we do know for sure that Warren’s strategy is to write insurance and invest the premiums. As long as he collects enough premium and his risks are diversified, he’s happy: for him, at least at 50,000 feet, the business model is all about collecting premiums and investing them. Writing long-dated puts is a good way to raise cash – as long as you don’t have to post collateral (which Warren didn’t).
- Even if he has written a worst-of put, this was not a particularly exotic derivative in 2006-7. Back then people were playing with a whole range of basket options (see for instance the mountain range trades originated by Soc Gen’s traders and rapidly taken up by the rest of the street). While these trade types might not be in options 101, they haven’t been cutting edge for twenty years.
- One of the hard things about running an equity derivatives book is getting enough long-dated vega. No one wants to sell it; everyone wants to buy it.
- So the reason there was a trade is the age-old two people wanting different things. Warren wanted cash, and saw the premium as good compensation for the insurance he was writing. His counterparties saw cheap vega that was hard to buy any other way, and a good credit. Two well informed parties with different takes on the world trading with each other is not, I am afraid, a scandal.