A Demon of Our Own Design
The author of the book, Richard Bookstaber, started as a quantitative specialist and a proprietary trader, has more than 3 decades of Wall Street experiences, from Morgan Stanley, Salomon Brothers, Citigroup, Moore Capital Management, to Ziff Brothers Investments. He was involved in the then popular financial product — portfolio insurance — that eventually caused the black Monday in October, 1987. Here is how it works:
If the portfolio increases in value and moves above the desired minimum floor value, the hedge is reduced, allowing the portfolio to enjoy a greater fraction of the market gain. If the portfolio declines in value, the hedge is increased, so that finally, if the portfolio value falls will below the floor price, the portfolio is completely hedged. Thus the portfolio is hedged when it needs it and is free to take market exposure when there is a buffer between its value and the floor value.
The hedging method of portfolio insurance is based on the Black-Scholes formula. Based on the equation, large firms set up programming trading against it. Under normal market situation, it DOES work very well. Unfortunately, it miserably failed on black Monday when based on Friday’s market data, portfolio insurance firms sold nearly half a billion dollars of S&P futures before the stock market opened. As the futures traders reacted to the market and the cash-futures arbitrage traders transmitted that activity to the NYSE floor, the flow hit a wall. Equity investors were not glued to their screens, ready to react en mass. Worse, because price dropped so violently that many potential buyers started to wonder what was happening and backed off completely, which made price plummet further. In turn, it triggered portfolio insurance programs to spit more sell orders. In the last 75 minutes of the day, the Dow dropped by 300 points.
His explanation of the Internet burst is also worth reading:
The end of the Internet bubble arrived when the period of restrictions on trading IPO holdings passed and the float expanded beyond the point of the demands of the extreme Internet optimists. Up to October 1999, the amount of IPO issuance that had become unlocked amounted to less than $40 billion. Then, in the last quarter of 1999, the IPO unlock exploded, with more than $50 billion worth released in December alone. In January 2000, another $65 billion worth of IPO shares were unlocked and came into the market, and nearly $100 billion worth was released in the following three months. There was now more stock looking for buyers than there were super-optimists ready to buy. The marginal share had to find a buyer who was not all that hyped up about Internet prospects, and the downward spiral began.
These two landmark stories characterize what the author has experienced in Wall Street. This 297-page book contains a lot more financial crises happened between these two major events that are worth reading. Readers can make the decision whether it is worth reading or not.
(Of course, that’s impossible given the fact that I was worth nothing at that time.)
