Warren Buffett, Black–Scholes, and the Valuation of Long-Dated Options

Abstract

In his 2008 letter to Berkshire shareholders, Warren Buffett presented a critique of the Black–Scholes option pricing model as a tool for valuing long-dated options, including options that Berkshire had written. Given Mr. Buffett’s track record, it is worth investigating precisely why he thinks the Black–Scholes model fails to provide a fair value for long-dated options. The alleged deficiencies in the model are, unfortunately, not transparent, because Mr. Buffett’s letter does not develop his viewpoint in terms of option pricing theory. In this article, Cornell fills the gap by interpreting Mr. Buffett’s argument in the context of option pricing theory and reveals that Mr. Buffett is really making a statement about political economics more than about option pricing.

TOPIC: Legal/regulatory/public policy