Product Description
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, or that offer the illusion of rewards without risks, 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.
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. Similar effects were felt when today’s e-trading momentum investors, who were essentially trying to create a “costless” call option, found themselves paying for it when they all rushed for the exit at the same time. “Capital Ideas and Market Realities” uncovers the hidden risks these strategies pose for market stability and investor wealth.
Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes
19 Aug
2:23 pm on August 19th, 2010
he book provides an extremely enlightening treatment of arcane financial strategies that have derived from Nobel Laureate winning option pricing theory. It is a well-written description of how very smart people are able to “outwit” other supposed very smart people by promising something for nothing. There will always be those who will dream up complicated strategies that purport to promise high return for low risk and thus demand a premium for providing their strategy. The book reminded me of Albert Einstein’s work for the Swiss Patent Office at the turn of the century. He would daily receive applications for new and different perpetual motion ideas. Sometimes the ideas were so complicated Einstein could not readily find their flaw. (Finally, he encouraged the patent office to pass a ruling stating that anyone wishing to patent something which broke the second law of thermodynamics had to submit an actual working unit.)
Portfolio insurance was the first large scale application of option pricing theory. Long-Term Capital Management, a highly leveraged hedge fund partnered by the Nobelists, was the second large scale application. Both promised free lunches. It is easy for the disciplined, long-term, individual investor to look at the 1987 crash and the LTCM debacle and conclude that it doesn’t matter. The ones who were harmed the most were the purveyors of these supposed perpetual motion machines as well as the investors who “played with this fire”. In fact, however, Jacobs’ book is a wake-up call that these new financial strategies have become so far reaching, that they can have significant impact not only on the financial markets, but on the global economy as well. The missing element in the book is a way for regulators to rein in an industry that is out of control and return it to its basic purpose: moving money from people that have it (investors) to people that need it and educating the investor on the risk/reward tradeoffs. The industry subrole of shifting risk from people who cannot accept it (e.g. farmers) to those who can (speculators) is also valid, however, it has become so pervasive and sophisticated that it begs for a return to sanity. Absent that, Jacobs’ book is an eye-opener, and a must read for anyone hoping to cope with today’s complicated markets.
Rating: 5 / 5
4:38 pm on August 19th, 2010
After reading Bernstein’s Capital Ideas, a cheerleading book for lognormal finance theory, which gushes over heroes, I had high expectations for Jacobs’ criticism Bernstein’s viewpoint. But Jacobs’ sole argument seems to be that portfolio insurance was a bad idea, and he repeats it too often. Many chapters are simply too repetitive and were written as if they’d been cut and pasted from different badly-written review articles. Even though the book is post-LTCM (post 10/98) most of the book is taken by with attacking of LOR’s pre-1987 idea of portfolio insurance, while the far more fascinating and more recent case of LTCM and the near collapse of the global finance system is hardly discussed. I recommend instead “The Vandal’s Crown” and “Inventing Money”.
Rating: 1 / 5
5:20 pm on August 19th, 2010
The book provides an extremely enlightening treatment of arcane financial strategies that have derived from Nobel Laureate winning option pricing theory. It is a well-written description of how very smart people are able to “outwit” other supposed very smart people by promising something for nothing. There will always be those who will dream up complicated strategies that purport to promise high return for low risk and thus demand a premium for providing their strategy. The book reminded me of Albert Einstein’s work for the Swiss Patent Office at the turn of the century. He would daily receive applications for new and different perpetual motion ideas. Sometimes the ideas were so complicated Einstein could not readily find their flaw. (Finally, he encouraged the patent office to pass a ruling stating that anyone wishing to patent something which broke the second law of thermodynamics had to submit an actual working unit.) Portfolio insurance was the first large scale application of option pricing theory. Long-Term Capital Management, a highly leveraged hedge fund partnered by the Nobelists, was the second large scale application. Both promised free lunches. It is easy for the disciplined, long-term, individual investor to look at the 1987 crash and the LTCM debacle and conclude that it doesn’t matter. The ones who were harmed the most were the purveyors of these supposed perpetual motion machines as well as the investors who “played with this fire”. In fact, however, Jacobs’ book is a wake-up call that these new financial strategies have become so far reaching, that they can have significant impact not only on the financial markets, but on the global economy as well. The missing element in the book is a way for regulators to rein in an industry that is out of control and return it to its basic purpose: moving money from people that have it (investors) to people that need it and educating the investor on the risk/reward tradeoffs. The industry subrole of shifting risk from people who cannot accept it (e.g. farmers) to those who can (speculators) is also valid, however, it has become so pervasive and sophisticated that it begs for a return to sanity. Absent that, Jacobs’ book is an eye-opener, and a must read for anyone hoping to cope with today’s complicated markets.
Rating: 5 / 5
6:18 pm on August 19th, 2010
This is a badly written, repetitive and self-serving account, largely, of the foolishness of “portflio insurance.” That things which are “just like” something else may not be so in reality, and that magic fixes in the market (which after all fly in the face of the rational-expectations/efficient-market hypotheses which often are built into the view of the market being relied on) I guess needs to be pointed out regularly, since hope of quick, uninformed, and painless fixes seem to reoccur with each new wave of financial charlatans and the greed they feed on. Jacobs does point out such problems for a particular, rather bizarre episode, and suggests, not too coherently, that such “scams” are still prevalent. However, He does this in a horribly repetitive and self-laudatory way that is not really very clearly argued.
Rating: 2 / 5