Over at Crossing Wall Street, Eddy E. has a post about shorting puts. I'm just trying to follow along and make sure I understand why this works, so consider this post to be me thinking aloud.
So Eddy is shorting puts, and from the sound of it, on individual stocks versus indices as he indicates The Great One has been doing.
(Financial Crookery has an analysis here as well.)
Anyway, from my reading, the situation described here is BRK holding stocks in their portfolio(s), then writing long dated (10 - 20 yr) puts against those indices. Writing puts is like selling insurance right, so it makes sense for what is essentially an insurance company to do so, on some level.
What we're doing in this situation is going short on a short - an implicit long. Our buyers for these puts are going to be people who think that, in the longer term, the various indices (and by extension, their components) are going to perform very poorly. The reasons they believe so are unimportant, relatively, at least if we are confident in our analysis. One imagines that BRK's CIO is confident in his analysis.
The puts themselves represent a hedge on the performance of the indices, which are probably fairly representative of the types of companies that BRK has expressed interest in owning in the future. That is, BRK is in the hunt for non-US based large corporations with large, steady cash flows, management experience, market undervaluation and/or large family control structures. Since private equity is somewhat handicapped by the credit markets, BRK is looking to do PE type takeouts on non-US large and mid-caps. Shorting the indices, which are composed largely of the types of competitors these targets would meet in their respective markets, becomes a hedge against underperformance off an equity index long position. Thus, we can probably deduce that BRK believes there is long term benefit to being long in these markets, and probably for more reasons than currency effects. (If that's all Buffett was hunting for, why not just go long the indices themselves and save the complexity?)
So BRK collects the premiums on the long dated puts. But are they really shorting them? Are we certain that BRK is not just selling the puts (either naked or covered)? The Forbes article seems a bit...shall we say "weak"...on the details. However, my thinking is that BRK just sold the puts as opposed to shorting them since in the latter case, at some point (probably way out in the future), BRK would have to cover its shorts. Is BRK's CIO really hedging his long term European equity exposure in this way? Its not impossible, especially since his holdings are fairly illiquid. However, he's also known as a long term holder, so why bother hedging. Selling the puts just gives him the ability to collect the premiums, and his equity holders should know that there can be volatility in the markets but also that he's not the short term type. Once collecting the premiums, he can invest them as he would like. BRK, as things stand now, can pay the claims if they happen to come due (e.g. the indices he sold against drop significantly enough).
I guess I'll just have to go digging a bit more in BRK's financial statements. However, if anyone wants to chime in to poke holes in my analysis, or just mention something I may have overlooked, by all means please do. Its a very curious arrangement that I'll take some time to investigate further in the near future.
Until next time...