Abstract: Capital Ideas and Market Realities Bruce J. Jacobs Blackwell 1999 Capital Ideas and Market Realities deals with modern financial theories, financial engineering, and causes of financial crashes. There is a brief forward by Nobel Prize winner Markowitz. Incidentally, Jacobs, although a holder of a doctorate in finance from the Wharton School of the University of Pennsylvania, is a principal in a successful quantitative portfolio management firm (Jacobs Levy Equity Management) with over $5B under management. He thus can bring both theory and experience to the problem of managing market risk. Much of the book discusses the major market crashes of recent years, notably the market crash of 1987. The Dow-Jones lost 22.6% of its value on one day, October 19, 1987, the largest percentage decline.in history. From its intra-day high on August 25 to the intraday low on October 20, the market declined by 37%, eliminating over a trillion dollars in investment value. Jacobs makes a convincing case that the severity of the crash can be blamed on an esoteric financial technique called portfolio insurance. A little financial background here may be useful. An American put option gives the privilege of selling a stock at a fixed price within a fixed period of time. Put options are frequently used to provide against loss for a particular stock. For instance, purchasing a put at $100 means you can always (within the term of the option) sell the stock for $100. Worried about the risk of a stock going down, individual investors sometimes buy put options to assure that they do not lose too much if it declines, while retaining the chance of making a profit if it goes up. Other investors who write (sell) the puts are providing the insurance in exchange for the price paid for the put. This is conceptually similar to a standard contract. However, portfolio is a trading strategy for managing risk, not a real contract that transfers risk. Modern financial theory shows that if stock prices move without gaps, that one can construct the equivalent of a put option by a suitable trading strategy (an appendix explains how this works for the non-specialist, and another appendix discusses option theory). In the eighties such strategies (often called portfolio insurance) were marketed to institutional investors (notably by Leland, O'Brien, Rubenstein Associates). These investors wanted to participate in the rising equity market, but were worried about the losses they could encounter in a market decline, what such loses would do to their clients and to their relationships with their clients. While the earlier plans provided for trading stocks, most of the later plans provided the desired exposure to stocks by trading index futures. Part of the book deals with the case against portfolio insurance, and why it is likely to be an unwise strategy for institutional investors. The theory behind portfolio requires that price changes be smooth, but in practice gaps occur. Obviously, if the option replication strategy depends on sales at a particular price, and the market drops suddenly to below that price, a key assumption behind the strategy is not met. Portfolio strategies are designed to limit losses over a specified period, often one year. This is inconsistent with optimal (rational) behavior for investors whose planning period is much longer than a year (such as the pension funds and endowments was sold to). The arguments against portfolio are powerful enough that one wonders why managers of at least 68 billion dollars in assets (total of list on p. 140) bought into such a strategy. The answer probably relates more to good salesmanship by the vendors of such schemes and to the desire of managers to be protected against loss of their jobs in the next market decline than to rational managers making decisions in their clients' interest. …
Publication Year: 2000
Publication Date: 2000-04-01
Language: en
Type: article
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