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

  • ID: 2210720
  • Book
  • 424 Pages
  • John Wiley and Sons Ltd
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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 [external URL] for further information.
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Foreword: Harry M. Markowitz, Nobel Laureate.


Part I: From Ideas into Products: .

1. Options and Option Replication. Options. How Options Took Off. Replicating Options. Real vs. Synthetic Options. A Risk Posed.


2. Synthetic Portfolio Insurance: The Sell. Asset Protection. Enhanced Returns. Unleashing the Aggressive Investor. Locking in Gains. Pension Fund Benefits. Beyond Equity. Job Security. "No Unhappy Surprises".


3. A Free Lunch? Sacrificing Wealth. Implementation Pitfalls.

i. Falling Through the Floor.

ii. Missing the Upside.

iii. Unexpected Transaction Costs. Job Insecurity.


4. Who Needs It? An Alternative: Buy Low and Sell High. Strategies in Practice. New and Improved.


Part II: The Crash of 1987: A Reality Check:.

5. The Fall of a Reigning Paradigm. An Efficient Crash. The Fundamental Things. The Psychic Crash.


6. Animal Spirits. Patterns. Noise. Overoptimism. Feedback Trading.


7. Bubbles, Cascades and Chaos. Bubbles. Informational Cascades. Chaos.


8. Futures and Index Arbitrage. The Futures – Stock Interface. The Mixed Evidence. Arbitrage and the Crash. A Massive Liquidity Event.


Part III: How Dynamic Hedging Moved Markets: .

9. Synthetic Puts and the 1987 Crash: Theory. A Fad. An Informational Cascade. Insurance, Arbitrage and Liquidity.


10. Synthetic Puts and the 1987 Crash: Evidence. Before the Crash. Black Monday. Roller Coaster Tuesday. Brady Commission and SEC Views.


11. Alibis I: The U. S. Crash. No Bounce Back. Insurers Far from Only Sellers. Investors Would Have Sold Anyway. Insurance Sales Insufficient. Insurance Trades not Correlated with Market Moves.


12. Alibis II: Across Time and Space. Explaining the 1929 Crash.

i. Margins Calls in 1929. Stocks Not in the S&P 500 Crashed. Explaining the International Crash. ii. The Synchronization of World Markets.

iii. Contagion Effects.


13. Did Insurance Live up to Its Name? Crash Conditions. Whipsaws. A Retreat. Why It Failed.


Part IV: Option Replication Resurrected:.

14. i. Mini–Crashes of 1989, 1991 and 1997, Friday the 13th, October 1989.

ii. Effect of Circuit Breakers.

iii. OTC Puts. November 15, 1991. Testing the Brakes: October 27, 1997.


15. Sons of Portfolio Insurance. Sunshine Trading. Supershares. Options Reborn. Expanding the Listed Option Menu. Synthetic Warrants, Swaps and Guaranteed Equity.

i. Warrants.

ii. Swaps.

iii. Guaranteed Equity.


16. The Enduring Risks of Synthetic Options Risks to Buyers. Risks to Dealers. Risks to Markets.


17. Living with Investment Risk. Predicting Market Moves. A Long–Run Perspective. A Premium for Patience.


18. Late Developments: Awful August 1998 and the long–term Capital Fallout. Behind the Price Moves. long–term Capital: A Hedge Fund in Need of a Hedge. A Frenzied Fall. Deja vu.

Summary. Epilogue.

Appendix A: The Continuing Debate.

Appendix B: Option Basics.

Appendix C: Option Replication.

Appendix D: Synthetic Options vs. Static–Allocation Portfolios.




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"Wall Street′s equivalent of the movieNightmare on Elm Street – Part 10. Portfolio insurance / dynamic hedging, the Freddy Krueger of the 1987 stock market crash, is back again with the recent growth of options and swaps. Jacobs builds the case for how portfolio insurance and dynamic hedging exacerbated the 1987 crash and points out that dynamic hedging has played a similar role in recent periods of market volatility."Robert Glauber, Executive Director, Brady Commission and former Under Secretary of the Treasury

"Bruce Jacobs, an investment manager who predicted before the 1987 crash that portfolio insurance would trigger chain–reaction selling, recently forecast that option–strategies (′the sons of portfolio insurance′) would play a similar, though more muted, role in a future debacle. Monday [October 27, 1997] provided damning evidence." The Wall Street Journal

"Every fiduciary should read this book. Investors have too often been taken in by promotions appealing to their basic human instincts of fear and greed. Bruce Jacobs shows how supposedly low–risk, seemingly infallible, investment strategies can backfire. His views on portfolio insurance helped steer our profit–sharing fund away from that craze in 1987. Today, especially in light of the long–term Capital Management fiasco, investors should know what Bruce has to say about derivatives trading strategies and market crashes." John E. Stettler, Vice President – Benefit Investments, Georgia–Pacific Corporation

"Bruce Jacobs demonstrates effectively that trend–following strategies like portfolio insurance are fair–weather techniques that may add to, rather than minimize, troubles when a major crash occurs." Charles P. Kindleberger, author of Manias, Panics, and Crashes: A History of Financial Crisis

"Bruce Jacobs has created an instant classic. Capital Ideas and Market Realities demonstrates how products that appeal to investors′ fears of short–term losses often ignore prudence and long–term value. This book is a must read for every investor." The Journal of Investing

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