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 dramaticprice 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.
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