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

Synopsis 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 Copyright © 1999 With a Foreword by Harry M. Markowitz, Nobel Laureate 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 U.S. 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, U.S. 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 greatest danger. Of particular concern is a trading strategy that grew out of the option pricing model developed by the late Fischer 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. Capital Ideas and Market Realities revisits the crash of October 19, 1987 to examine an option replication strategy known as portfolio insurance. Marketed as a free lunch, offering excess returns at low or no risk, portfolio insurance grew into a $100 billion industry by the fall of 1987. The book documents portfolio insurance's contribution to the crash, examining and dismissing multiple alternative theories along the way. It goes on to look at the so-called "sons of portfolio insurance"—instruments and strategies that have emerged since the 1987 crash, offering similar promises of no-risk returns. These include hundreds of billions of dollars in over-the-counter options and swaps, as well as various "guaranteed" equity products. Their advent has been associated with a number of market disruptions. An investigation of Long-Term Capital Management and the summer of 1998 reveals how derivatives-dependent hedge fund strategies can have effects similar to those of option replication. In effect, when Long-Term Capital Management's supposedly low-risk strategies reached their liquidity limits, the firm was forced to sell, mechanistically, into declining markets. As with the selling related to portfolio insurance in 1987, the result was precipitous drops in wealth for most investors. Back to Top