By Alyssa A. Lappen
Institutional Investor | August 1999
With the U.S. stock market continuing to punch through record levels, pundits occasionally trot out the usual suspects that might end the financial exuberance: resurgent inflation, trouble in the Balkans, 100 new Internet IPOs.
One money manager, however, is warning about a very different and more complicated scenario that could trip up the markets. It takes a little options theory to make sense of the logic. You’re not likely to hear about it at cocktail parties. But Bruce Jacobs may have history on his side.
In his new book, Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes, Jacobs, co-founder and principal of Roseland, New Jersey-based Jacobs Levy Equity Management, argues that recent market breaks have been caused by new forms of derivatives-related forced trading. As investors seek to protect or adjust their portfolios with options strategies, he asserts, they ironically create an environment where a moderate decline in the market could turn into a brutal fall or even a crash.
“That’s precisely what happened in 1987,†says Jacobs. “October 19 saw trading equivalent to many days’ volume, and people reacted as if there were negative fundamental information when there was none.†In 1987 a then-popular form of hedging called portfolio insurance was blamed by some regulators and investors for at least exacerbating if not causing the market crash. Continue reading “Jacobs’ lather”
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