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Introducing an Important Book
on Stock Market Crashes
by Bruce I. Jacobs

pad

 

Research & Reviews

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



By Bruce I. Jacobs,
co-founder and principal of Jacobs Levy Equity Management

With a Foreword by Harry M. Markowitz, Nobel Laureate

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  • Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes, by Bruce I. Jacobs, with a foreword by Harry M. Markowitz, Nobel laureate, Blackwell Publishers, Oxford, UK and Malden, MA, 1999.
    This work is about some investment strategies that have arisen from modern capital ideas, and the consequences for investors and markets. When these strategies are sold as free lunches without proper disclosure of their risks, they give rise to a faddish demand, which inevitably leads to a debacle not only for their investors, but for the overall securities markets. Two examples are the advent of dynamic strategies designed to replicate options positions, known in the 1980s as portfolio insurance, and the highly leveraged arbitrage strategies of hedge fund Long-Term Capital Management. Below, citations, both prior and subsequent to publication, and reviews of the work are provided. The debates section covers the current controversy, including the disclosure debate with the CFA Institute's (formerly Association for Investment Management and Research) Financial Analysts Journal, and the market impact debate with Mark Rubinstein of Leland O'Brien Rubinstein Associates and William Brodsky, Chairman and CEO of the Chicago Board Options Exchange. Abstracts of various articles related to this work are also provided.

         Citations
    • Dealing With Financial Risk, by David Shirreff, The Economist in association with Bloomberg Press, Princeton, NJ, 2004.
    • "When Risk Avoidance Goes Too Far," by Barry B. Burr, Pensions & Investments, July 12, 2004.
    • "Weapons of Mass Panic," by William P. Barrett, Forbes Magazine, March 15, 2004.
    • Dynamics of Markets: Econophysics and Finance, by Joseph L. McCauley, Cambridge University Press, Cambridge, U.K., 2004.
    • Finance, A Fine Art, by Michel Fleuriet, John Wiley, West Sussex, UK, 2003.
    • "Relative Performance of Dynamic Portfolio Insurance Strategies: Australian Evidence," by Binh Huu Do, Accounting and Finance, November 2002.
    • "Risk-Neutral Option Pricing From EPV Without CAPM," by David Johnstone, Journal of Financial Education, Summer 2002.
    • "The Emperor has no Clothes: Limits to Risk Modelling," by Jón Daníelsson, Journal of Banking & Finance, July 2002.
    • "Portfolio Hedging and Risk Premium," by Joseph D. Marsden, Wilmott, June 30, 2002.
    • "Can you beat the markets?" by Peter Bennett, The Handbook of World Stock, Derivative & Commodity Exchanges, Mondo Visione, London, UK, 2002.
    • Treasury of Investment Wisdom, by Dean LeBaron and Romesh Vaitilingam, John Wiley, New York, 2002.
    • "The Credit Bubble Bulletin: The Son of Portfolio Insurance," by Doug Noland, www.PrudentBear.com, May 25, 2001.
    • Derivatives: The Tools That Changed Finance, by Phelim Boyle and Feidhlim Boyle, Risk Books, London, UK, 2001.
    • Physics of Finance, by Kirill Ilinski, John Wiley, West Sussex, UK, 2001.
    • "Merton Miller and Modern Finance," by René M. Stulz, Keynote address to the Financial Management Association International Annual Meeting, Financial Management, Winter 2000.
    • When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein, Random House, New York, 2000.
    • Derivatives: The Wild Beast of Finance, by Alfred Steinherr, John Wiley, West Sussex, UK, 2000.
    • The Money Flood: How Pension Funds Revolutionized Investing, by Michael J. Clowes, John Wiley, New York, 2000.
    • “The Case Against Single-Stock Futures,” by Joseph Weber, Business Week, May 22, 2000.
    • Lessons From the Collapse of Hedge Fund, Long-Term Capital Management, Financial Risk Institute (IFCI) case study by David Shirreff, 2000.
    • “A Bumpy Ride to the Market,” by John Plender, Financial Times, January 3, 2000.
    • “Long-Term, The Sequel: Old Strategies,” by Mitchell Pacelle, The Wall Street Journal, December 17, 1999.
    • “Why Stock Options Are Really Dynamite,” by Roger Lowenstein, The Wall Street Journal, November 6, 1997. (1) article
    • “A Decade and a Bull Ride Later, Complacency Reigns,” by Floyd Norris, The New York Times, October 19, 1997. (1)
         Reviews
    • The Economic Journal, by David Gowland, June 2001. review
    • Journal of Economic Literature, by Anat R. Admati, December 2000. review
    • The Journal of Alternative Investments, by Thomas Schneeweis, Fall 2000. review
    • Financial Analysts Journal, by Martin S. Fridson, July/August 2000. review
    • The Journal of Social, Political and Economic Studies, by Edward M. Miller, Spring 2000. review
    • “The Point of a Put,” by Michael Brennan, Risk, April 2000. review (Also see Jacobs's Letter to the Editor, Risk, May 2000.) letter
    • Abstract of NYSSA Programs, April 2000. review
    • “The ‘Nemesis of Portfolio Insurance’ Argues His Case,” by Porus P. Cooper, Global Investment, December 1999. (Also see Jacobs's correction in Letters to the Editor, Global Investment, March 2000.)
    • “Taming the Human Element,” by Shanta Acharya, The Times Higher Education Supplement, November 19, 1999.
    • “Jacobs’s Lather,” by Alyssa A. Lappen, Institutional Investor, August 1999. article
    • “More to Say about Crash,” by Michael J. Clowes, Pensions & Investments, July 12, 1999. review
         Debates
    • "Bruce Jacobs's Comments on AIMR's Proposed Research Objectivity Standards," August 12, 2002. letter
      • "Bids & Offers: Analyst, Heal Thyself," by William Power and Kate Kelly, The Wall Street Journal, September 13, 2002. article
      • Letters in Support of Bruce Jacobs's Proposal for AIMR to adopt Research Objectivity Standards for its own Publications
        • Jose Arau, CalPERS Principal Investment Officer and President of the Security Analysts of Sacramento, October 3, 2002. letter
        • Deborah J. Weir, President of the Stamford Society of Investment Analysts, October 8, 2002. letter
        • Alexander Singer, President of the Hellenic Association of Investment Professionals, October 9, 2002. letter
      • "AIMR's Objectivity Lesson," Global Investor, November 2002. article
      • "AIMR and 'Best Practices' on Ethics," by Bruce I. Jacobs, Pensions & Investments, December 9, 2002. article
    • "FAJ, AIMR Ethical Issues," by Bruce I. Jacobs, Pensions & Investments, October 1, 2001. letters
      • "An Open Letter to AIMR and the Financial Analysts Journal," by Bruce I. Jacobs, October 1, 2001. letter
      • "AIMR’s Misinterpretation," by Bruce I. Jacobs, Pensions & Investments, November 12, 2001 (letter in response to Patricia Doran Walters, "AIMR Strict on Ethics Code," Pensions & Investments, October 15, 2001). letters
    • “Postscript,” by Martin S. Fridson, Financial Analysts Journal, January/February 2001. postscript (See Fridson’s original review, Financial Analysts Journal, July/August 2000.)
      • “Postscript: Author’s Comment,” by Bruce I. Jacobs Financial Analysts Journal, May/June 2001. letters
      • “The Marketing of Portfolio Insurance and the Magnification of Market Risk: The Whole Story,” by Bruce I. Jacobs www.cimrbook.com, 2001. (The complete text of the abbreviated “Postscript: Author’s Comment,” Financial Analysts Journal, May/June 2001.) complete text
      • “Postscript: Reviewer’s Response,” by Martin S. Fridson, Financial Analysts Journal, May/June 2001. letters
      • "The Response to Fridson's ' "Postscript": Reviewer's Response,' " by Bruce I. Jacobs, June 20, 2001. letter
      • "Praise for Book Turns to Criticism," by Barry B. Burr, Pensions & Investments, June 25, 2001. article
      • "Rubinstein to Stay on Editorial Board of FAJ Despite Talking with Fridson," by Barry B. Burr, Pensions & Investments, September 3, 2001. article
    • “2000 Hall of Fame Roundtable: Portfolio Insurance Revisited (April 14, 2000),” Bruce Jacobs debates Mark Rubinstein, Professor, University of California, Berkeley and Partner, Leland O’Brien Rubinstein Associates, and William Brodsky, Chairman and CEO of the Chicago Board Options Exchange, Derivatives Strategy, August 2000. debate
  • Related Articles on the Tech Bubble and Crash
    • "Momentum Trading: The New Alchemy," by Bruce I. Jacobs, The Journal of Investing, Winter 2000. article
      Momentum traders buy stock (often on margin) as prices rise and sell as prices fall. In essence, they are trying to obtain the benefits of a call option--upside participation with limited risk on the downside--without any payment of an option premium. The strategy appears to offer a chance of huge gains with little risk and minimal cost, but its real risks and costs become known only when it's too late--after the strategy has failed, and taken markets down with it.

    • "Another 'Costless' Strategy Roils Market," by Bruce I. Jacobs, Pensions & Investments, May 29, 2000. article
      The momentum trading in tech stocks resembles the trend-following trading underlying portfolio insurance and undertaken by Long-Term Capital Management when they were forced to unwind their gargantuan arbitrage trades. It has also led to a similar market debacle.
  • Related Articles on Long-Term Capital Management
    • "A Tale of Two Hedge Funds," by Bruce I. Jacobs and Kenneth N. Levy, in Jacobs and Levy, Eds., Market Neutral Strategies, John Wiley, The Frank. J. Fabozzi Series, Hoboken, NJ, 2005.
      The blow-ups of two notorious hedge funds hold some lessons for investors considering market neutral strategies. Askin Capital Management's supposedly market neutral posture in mortgage instruments was anything but market neutral. In fact, the firm was extremely susceptible to rising interest rates, and succumbed as the Fed raised rates in 1994. Long-Term Capital Management's sophisticated risk aggregator was supposed to ensure the neutrality of the firm's complicated arbitrage trades. Yet it failed to account for how extreme price movements would affect correlations between different asset classes and the willingness of other arbitragers to take on positions as arbitrage spreads widened. The Russian debt crisis in the summer of 1998 brought the firm to its knees, and the resulting selling pressure roiled financial markets.

    • "Why Hedge Funds Need To Be Kept in Check," by Bruce I. Jacobs, Global Pensions, September 1999. article
      Hedge funds can have outsize impacts on public markets, as Long-Term Capital Management demonstrated in 1998. Enhanced disclosure may be able to ameliorate similar bouts of instability in the future.

    • "When Seemingly Infallible Arbitrage Strategies Fail," by Bruce I. Jacobs, The Journal of Investing, Spring 1999. article
      Seemingly infallible arbitrage strategies can fail. When they do, they can take the markets down with them. The near collapse of Long-Term Capital Management bears some eerie parallels to the collapse of portfolio insurance, and the market, in October 1987.

    • "Long-Term Capital's Short-Term Memory," by Bruce I. Jacobs, Pensions & Investments, October 5, 1998. article
      The highly leveraged arbitrage activities of LTCM, much like portfolio insurers' hedging activities in 1987, allowed a very small number of operators to become a threat to the stability of global financial markets.
  • Related Articles on Portfolio Insurance, Option Replication and Dynamic Hedging
    • "Financial Market Simulation," by Bruce I. Jacobs, Kenneth N. Levy, and Harry M. Markowitz, The Journal of Portfolio Management, 30th Anniversary Issue, September 2004. (2) For information on the JLM Simulator, go to http://www.jacobslevy.com/jlm_simulator.htm
      When they want to see how complex systems work, scientists often turn to asynchronous-time simulation, which allows processes to change sporadically over time, typically at irregular intervals. While rarely used in finance today, such models may turn out to be valuable tools for understanding how markets respond to changes in the participation rates of different types of investors, for example, or to changes in regulatory or investment policies. The asynchronous, discrete-event, stock market simulator described here allows users to create a model of the market, using their own inputs. Users can vary the numbers of investors, traders, portfolio analysts, and securities, as well as their investing and trading decision rules. Such a simulation may be able to provide a more realistic picture of complex markets.

    • "Risk Avoidance and Market Fragility," by Bruce I. Jacobs, Financial Analysts Journal, January/February 2004. article
      Investors who buy "insurance" against a decline in stocks, bonds, or other financial markets are shifting that risk onto the financial institutions providing such "insurance." These insurance providers frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging. As more and more investors demand insurance, however, there is more trend-following trading, more market volatility, and more demand for insurance. At some point, the selling required to replicate an option on the market can create a liquidity crisis. In such an event, "insurance" products can fail, along with the firms offering them, giving rise to systemic risk.

    • "The World According to Bruce Jacobs," Derivatives Strategy, February 2000. (Interview with Editor Joe Kolman) interview
      Portfolio insurance, highly leveraged arbitrage, and the options written by OTC dealers and investment banks are forms of "free-lunch" strategies that seem to promise the rewards of investing without the risks. In the absence of better disclosure on the part of vendors and a greater understanding on the part of investors, the trend-following, mechanistic trading underlying these strategies has the power to decimate capital markets, as it did in 1987 and 1998.

    • "Option Pricing Theory and its Unintended Consequences," by Bruce I. Jacobs, The Journal of Investing, Spring 1998. (3) article
      Like any revolution, the options revolution that began with the publication of the Black-Scholes-Merton option pricing formula has had some unintended side effects. Of concern to all investors should be the potentially dangerous increase in market instability created by the trading strategies option sellers use to hedge their market exposures. Dynamic hedging rules that call for buying as market prices rise and selling as they fall have wreaked havoc with markets in the past and are likely to do so again in the future.

    • "Nobel-Winning Strategy Criticized: Jacobs says Model Adds to Volatility," by Barry B. Burr, Pensions & Investments, December 8, 1997. article
      In this article, Barry Burr outlines Bruce Jacobs's view that option replication can pose dangers for market stability, and presents the counter arguments of Nobel laureates Myron Scholes and Merton Miller, who argue that options, and option-based strategies, do not increase market volatility or mispricing.

      • "Option Replication and the Market's Fragility," by Bruce I. Jacobs, Pensions & Investments, June 15, 1998. article
        Bruce Jacobs responds to some of the defenses of portfolio insurance raised by Nobel laureates Myron Scholes and Merton Miller in "Nobel-Winning Strategy Criticized." While Scholes had argued that any mispricing caused by option replication could not persist for long in efficient markets, Jacobs points out that mispricing can persist because trading against it can be costly in the short term. Miller had argued that option replication and portfolio insurance were preceded by margin buying and stop-loss strategies, which did not lead to instability. But Jacobs cites the crash of 1929, in which margin buying and selling played pivotal roles, and notes that synthetic portfolio insurance was essentially a giant, institutional stop-loss order. While Scholes blames the crash on illiquidity, Jacobs identifies synthetic portfolio insurance's trend-following selling as the cause of that illiquidity.

    • "The Darker Side of Options Pricing Theory," by Bruce I. Jacobs, Pensions & Investments, November 24, 1997. article
      The option pricing formula developed by Nobel Prize winners Myron Scholes and Robert Merton in conjunction with the late Fischer Black recognizes the theoretical equivalence between an option and dynamic positions in the underlying risky asset and cash. The option pricing formula also opened the door to option replication; by taking and trading positions in the underlying risky asset and cash, investors can replicate the behavior of a desired option. Replication of long option positions, however, requires buying as the underlying asset rises and selling as it falls. Option replication thus has the potential to destabilize markets. This is precisely what happened in 1987, when portfolio insurance, a form of option replication, led to the crash of October 19.

      • "Options and Market Fall," by Paul Stevens, Pensions & Investments, January 12, 1998. letters
        Paul Stevens, president of the Options Industry Council, responds to "The Darker Side of Options Pricing Theory." He argues that investors using options can avoid having to sell during market downturns, and suggests that the light trading volume in options during the October 27, 1997 market fall proves that options were not the cause of that decline.

      • "Options Can Destabilize," by Bruce I. Jacobs, Pensions & Investments, January 26, 1998. letters
        Bruce Jacobs responds to Paul Stevens, pointing out that what is true for option buyers is not necessarily true for option sellers. For option sellers, changes in market level can necessitate dynamic hedging. This will show up in trading volume (and perhaps price changes) in the underlying spot and futures markets.

    • "Crash Showed Danger of 'Insured' Assets: Fragility of Market Highlighted," Pensions & Investments, October 13, 1997. article
      In October 1997, Pensions & Investments printed preliminary versions of Chapters 15 and 16 from Capital Ideas and Market Realities. The first chapter describes the new techniques and instruments for insuring equity portfolio value that have emerged since the crash, including sunshine trading, SuperShares, OTC options, LEAPS and FLEX options, swaps, warrants, and option-embedded bonds (also known as guaranteed equity). The second chapter discusses the risks some of these strategies (particularly OTC options) pose for investors, issuers, and the markets.

    • "Jacobs Blames Portfolio Insurance," by Barry B. Burr, Pensions & Investments, September 29, 1997. article
      This article commemorating the 10th anniversary of the 1987 crash highlights Bruce Jacobs's theory of how portfolio insurance contributed to the event. In particular, portfolio insurance trades helped raise market levels above fundamental values before the crash, while selling by insurers, and by other investors responding to insurance sales, brought the market to its knees on October 19, 1987.

    • "Viewpoint on Portfolio Insurance: It's Prone to Failure," by Bruce I. Jacobs, Pensions & Investment Age, November 16, 1987. article
      In the 1987 crash, portfolio insurance failed to provide the portfolio protection it purported to guarantee, and helped to contribute to the very conditions that spelled its demise.

    • "Investors Rush for Portfolio Insurance: Skeptics Worry About Effects on Stock Markets," by George Anders, The Wall Street Journal, October 14, 1986.
      This "update" on the growth of the portfolio insurance industry notes some of the hidden costs. According to Bruce Jacobs, "In a fast-moving market, portfolio insurance users can get bagged." This apparently happened on September 11-12, 1986, when insured portfolios were forced to sell futures at below-spot prices.

    • "Hidden Risks in Portfolio Insurance," by Daniel Forbes, Dun's Business Month, September 1986.
      In this assessment of portfolio insurance's pros and cons, Bruce Jacobs has the last words: "Everyone has a natural tendency to avoid sleepless nights. Portfolio insurance is performance insurance for money managers and career insurance for corporate pension officers."

    • "A Public Debate on Dynamic Hedging" (with Bruce I. Jacobs and John O'Brien of Leland O'Brien Rubinstein Associates), in Innovative Portfolio Insurance Techniques: The Latest Developments in 'Dynamic Hedging', Institute for International Research, New York (videotape), June and December 1986.
      Playing "devil's advocate" in this debate with portfolio insurance vendors, Bruce Jacobs questions the ability of portfolio insurance to maximize investor wealth and points out its susceptibility to gaps in underlying stock prices and spot-futures basis risk. In general, natural "sellers" of portfolio insurance (including contrarians and value investors, who sell as prices rise and buy as prices fall) can be expected to outperform buyers of portfolio insurance. O'Brien contends that an insured strategy can be expected to outperform an uninsured strategy by more than 100 basis points a year, even after accounting for transaction costs.

      • "Portfolio Insurance's Merits Spur Debate," by Trudy Ring, Pensions & Investment Age, July 7, 1986. article
        A little over a year before the 1987 crash, Bruce Jacobs debated John O'Brien of insurance provider Leland O'Brien Rubinstein Associates at a New York conference. O'Brien argued that an insured portfolio will outperform an uninsured portfolio. Jacobs pointed out that the performance periods highlighted in vendors' ads are often ones of poor stock price performance, in which insured portfolios are poised to do well because of their exposure to the (better-performing) cash-equivalent asset. He argued that a constant-mix portfolio will outperform portfolio insurance over the long term. Furthermore, Jacobs argued, rather than locking in past gains, portfolio insurance could end up locking its buyers out of future gains.

      • "Flocking to Hear the Dynamic 'Gospel'," Futures, August 1986.
        Futures magazine covered the New York conference where Bruce Jacobs debated Leland O'Brien Rubinstein Associates' John O'Brien. Jacobs championed uninsured portfolios for pension fund wealth accumulation. O'Brien stated that portfolio insurance "is more satisfying psychologically for pension managers."

    • "Dynamic Strategies and the Practice of Investment Management: A Debate" (with Bruce I. Jacobs and John O'Brien of Leland O'Brien Rubinstein Associates), Index Futures, Index Options and Dynamic Portfolio Strategies, Berkeley Program in Finance, Monterey, California, September 1984.
      At this early conference on portfolio insurance, Bruce Jacobs debated John O'Brien of Leland O'Brien Rubinstein Associates, the leading vendor of portfolio insurance. O'Brien shared with conference participants a paper by LOR's Hayne Leland, "Portfolio Insurance Performance, 1928-1983," which argued that portfolio insurance, a strategy of dynamically switching between risky and riskless assets, could outperform static-mix portfolios and, with the use of leverage, outperform buying and holding the S&P 500. LOR's claim was that annualized returns could be increased by 100 to 200 basis points, after accounting for trading costs. Jacobs, showing charts from his paper, "Is Portfolio Insurance Appropriate for the Long-Term Investor?", compared empirical return distributions for buy-and-hold, portfolio insurance, and constant-mix portfolios. He found that portfolio insurance reduces returns, and is subject as well to performance pitfalls, including gaps in underlying prices. Gaps would be more problematic with a leveraged portfolio.

    • "Is Portfolio Insurance Appropriate for the Long-Term Investor?" by Bruce I. Jacobs, Prudential Asset Management Company, June 1984.
      Empirical results for portfolio insurance, constant-mix portfolios, and buying and holding the S&P 500 over the 1928-82 period indicate that a portfolio insurance policy would have underperformed over the period and would have suffered substantial opportunity costs in some years by being shut out of market rebounds. An examination of theoretical considerations indicates that certain applications of portfolio insurance also have some very strange implications for investors' utility functions.

    • "The Portfolio Insurance Puzzle," by Bruce I. Jacobs, Pensions & Investment Age, August 22, 1983. article
      Portfolio insurance is a synthetic protective put that relies on moving portfolio assets into risky stocks as stock prices rise and into a risk-free asset as stock prices fall. The opportunity cost of the hedged position in the risk-free asset will seriously hinder the long-term performance of the strategy. Furthermore, the insured portfolio is susceptible to pitfalls such as gaps in underlying prices and unanticipated increases in volatility. If gaps are extreme enough, the insured portfolio may not be able to transfer to the risk-free asset at the prices required to preserve the supposedly guaranteed floor.

      • "Research Questioned," by John O'Brien, Pensions & Investment Age, September 19, 1983. article
        In a letter to the editor, Leland O'Brien Rubinstein Associates' John O'Brien questions the methodology and lengthy sample period behind the results reported in "The Portfolio Insurance Puzzle." O'Brien finds the "conclusion that [portfolio insurance] reduced long-term gains is precisely 180 degrees opposite to reality."

      • "Jacobs Responds," by Bruce I. Jacobs, Pensions & Investment Age, November 14, 1983. article
        In this response to John O'Brien, Bruce Jacobs defends his use of the 1928-82 time period (as compared with the 10-year, 1973-82 period highlighted by Leland O'Brien Rubinstein Associates). He also provides results for the 1939-82 span, a period that excludes the two years (1933 and 1938) when the portfolio insurance strategy "stopped out" and was therefore "shut out" of subsequent market rallies. The results show that a buy-and-hold S&P 500 strategy and a constant-mix strategy (S&P 500 and Treasury bills) would have ended up with higher returns than the insured portfolio.

    • "Portfolio Insurance Memorandum," by Bruce I. Jacobs, Prudential Asset Management Company, January 17, 1983. memorandum
      Written soon after the "birth" of portfolio insurance, this memo describes the basic theory of portfolio insurance and points out some potential problems. The latter include the arbitrary term of the insurance "policy," the impact of unexpected volatility on the strategy's performance, and the possible destabilizing effect of portfolio insurance's trades on securities markets.

    • "Long-Term Asset Mix Guidelines for Pension Asset Management Clients," by Bruce I. Jacobs, Prudential Asset Management Company, 1983.
      This piece discusses the application of some concepts from modern portfolio theory, including diversification and efficient frontiers, to the determination of appropriate multi-asset portfolios for long-term investors.
    _____________________________________________
    (1) Pre-publication manuscript.
    (2) The Journal of Investing Outstanding Paper Award winner.
    (3) Presented at Carnegie Mellon University and Princeton University, September 2005.

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