Capital Ideas and Market Realities Option Replication, Investor Behavior, and Stock Market Crashes

by Jacobs, Bruce I.

• ISBN13: 9780631215554
• ISBN10: 0631215557
• Edition: 1st
• Format: Paperback
• Copyright: 1999-08-03
• Publisher: Wiley-Blackwell

Summary

The summer and fall of 1998 witnessed some of the most turbulent financial markets the world has ever seen. The implosion of the Russian financial markets and investors' ensuing flight to quality propelled the giant hedge-fund, long-term Capital Management, to the brink of collapse and left the investment portfolios of many of Wall Street's major banks and brokerage houses teetering on the brink. The US equity market dropped precipitously at the end of August and continued over the next month to experience levels of volatility not seen since the major crash of October 1987. Yet, within months of the August sell-off, US stocks had bounced back to new highs. How can markets fall so fast and recover so quickly?Bruce Jacobs sifts through the history of modern finance, from the efficient market hypothesis to behavioral psychology and chaos theory, to determine the cause of recent market crashes. He finds that some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, some strategies that purport to reduce the risk of investing can pose the greater danger.Of particular concern is a trading strategy that grew out the option pricing model developed by the late Fisher Black and Nobel laureates Myron Scholes and Robert Merton. Used by market professionals, this strategy, known as option replication, requires mechanistic selling as stock prices decline and buying as stock prices rise. When a large enough number of investors engage in this type of trend-following dynamic hedging, their trading demands can sweep markets along with them, elevating stock prices at some times and causing dramatic price drops at others.Dynamic hedging associated with some $100 billion in option-replication strategies caused a US stock market crash in 1987 that wiped out almost a quarter of US equity value and ignited market crashes around the world. Today, the same dynamic hedging underlies hundreds of billions of dollars in institutional and retail products. Capital Ideas and Market Realities uncovers the hidden risks these products pose for market stability and investor wealth.Visit the author's website at http://www.cimrbook.com for further information.

Author Biography

Bruce I. Jacobs is a cofounder and principal of Jacobs Levy Equity Management, an investment counselor with $5 billion in institutional assets under management, located in Roseland, New Jersey. He holds a doctorate in finance from the Wharton School of the University of Pennsylvania. Dr Jacobs is co-author, with Kenneth N. Levy, of the book, Equity Management: Quantitative Analysis for Stock Selection.

Table of Contents

List of Illustrations	ix
Foreword	xiii
Harry M. Markowitz
Nobel Laureate
Acknowledgments	xix
Introduction	1	(14)
PART I: FROM IDEAS INTO PRODUCTS	15	(54)
Options and Option Replication	19	(16)
Options	20	(1)
How Options Took Off	21	(4)
Replicating Options	25	(2)
Real versus Synthetic Options	27	(2)
A Risk Posed	29	(2)
Summary	31	(4)
Synthetic Portfolio Insurance: The Sell	35	(12)
Asset Protection	35	(1)
Enhanced Returns	36	(3)
Unleashing the Aggressive Investor	39	(1)
Locking in Gains	40	(2)
Pension Fund Benefits	42	(2)
Beyond Equity	44	(1)
Job Security	45	(1)
``No Unhappy Surprises''	45	(1)
Summary	46	(1)
A Free Lunch?	47	(12)
Sacrificing Wealth	48	(1)
Implementation Pitfalls	49	(6)
Job Insecurity	55	(1)
Summary	56	(3)
Who Needs It?	59	(10)
An Alternative: Buy Low and Sell High	60	(2)
Strategies in Practice	62	(2)
Summary	64	(5)
PART II: THE CRASH OF 1987: A REALITY CHECK	69	(52)
The Fall of a Reigning Paradigm	75	(8)
An Efficient Crash	76	(1)
The Fundamental Things	77	(3)
The Psychic Crash	80	(1)
Summary	81	(2)
Animal Spirits	83	(12)
Patterns	85	(1)
Noise	86	(2)
Overoptimism	88	(2)
Feedback Trading	90	(1)
Summary	91	(4)
Bubbles, Cascades, and Chaos	95	(10)
Bubbles	95	(3)
Informational Cascades	98	(2)
Chaos	100	(3)
Summary	103	(2)
Futures and Index Arbitrage	105	(16)
The Futures-Stock Interface	107	(1)
The Mixed Evidence	108	(3)
Arbitrage and the Crash	111	(3)
A Massive Liquidity Event	114	(4)
Summary	118	(3)
PART III: HOW DYNAMIC HEDGING MOVED MARKETS	121	(82)
Synthetic Puts and the 1987 Crash: Theory	125	(22)
A Fad	127	(12)
An Informational Cascade	139	(3)
Insurance, Arbitrage, and Liquidity	142	(3)
Summary	145	(2)
Synthetic Puts and the 1987 Crash: Evidence	147	(14)
Before the Crash	147	(4)
Black Monday	151	(4)
Roller Coaster Tuesday	155	(1)
Brady Commission and SEC Views	156	(2)
Summary	158	(3)
Alibis I: The US Crash	161	(12)
No Bounce Back	161	(2)
Insurers Far From Only Sellers	163	(4)
Investors Would Have Sold Anyway	167	(1)
Insurance Sales Insufficient	168	(2)
Insurance Trades Not Correlated with Market Moves	170	(1)
Summary	171	(2)
Alibis II: Across Time and Space	173	(14)
Explaining the 1929 Crash	173	(3)
Stocks Not in the S&P 500 Crashed	176	(1)
Explaining the International Crash	176	(7)
Summary	183	(4)
Did Insurance Live Up To Its Name?	187	(16)
Crash Conditions	187	(3)
Whipsaws	190	(1)
A Retreat	191	(4)
Why It Failed	195	(6)
Summary	201	(2)
PART IV: OPTION REPLICATION RESURRECTED	203	(92)
Mini-Crashes of 1989, 1991, and 1997	207	(16)
Friday the 13th, October 1989	209	(7)
November 15, 1991	216	(2)
Testing the Brakes: October 27, 1997	218	(3)
Summary	221	(2)
Sons of Portfolio Insurance	223	(20)
Sunshine Trading	223	(4)
Supershares	227	(4)
Options Reborn	231	(3)
Expanding the Listed Option Menu	234	(1)
Synthetic Warrants, Swaps, and Guaranteed Equity	235	(6)
Summary	241	(2)
The Enduring Risks of Synthetic Options	243	(20)
Risks to Buyers	244	(4)
Risks to Dealers	248	(7)
Risks to Markets	255	(5)
Summary	260	(3)
Living with Investment Risk	263	(10)
Predicting Market Moves	265	(1)
A Long-Run Perspective	266	(1)
A Premium for Patience	267	(3)
Summary	270	(3)
Late Developments: Awful August 1998 and the Long-Term Capital Fallout	273	(22)
Behind the Price Moves	275	(3)
Long-Term Capital: A Hedge Fund in Need of a Hedge	278	(5)
A Frenzied Fall	283	(8)
Deja Vu	291	(2)
Summary	293	(2)
Epilogue	295	(42)
Appendix A: The Early Debate	301	(8)
Appendix B: Option Basics	309	(12)
Appendix C: Option Replication	321	(14)
Appendix D: Synthetic Options versus Static-Allocation Portfolios	335	(2)
Glossary	337	(12)
Bibliography	349	(24)
Index	373