The following reproduces two of the chapters from the newly completed book on the Oct. 19, 1987, stock market crash, "Capital Ideas and Market Realities: The true story of the crash of 1987 and the lessons we have (and haven't) learned."
The author, Bruce I. Jacobs, principal and co-chief investment officer of Jacobs Levy Investment Management Inc., Roseland,
N.J., hopes to have the more than 400-page manuscript published next year.
An article on the book was published in the Sept. 27 issue of Pensions & Investments.
The chapters excerpted here discuss the risks posed by certain investment vehicles and strategies that he asserts caused the record one-day fall in the market 10 years ago and that exist in similar investing approaches today in the market. The bibliographical references, which appear in the book, have been cut from the excerpt.
His work is 1997 Jacobs Levy Equity Management Inc.
We felt ultimately that demand for hedges would persist.
- John O'Brien, 1993
On the one hand, the crash of 1987 highlighted two major problems with portfolio insurance as carried out by dynamic asset allocation. First, it showed the strategy of self-insurance upon which synthetic portfolio insurance rests is not insurance in the true sense of the word; the market declined to serve as the guarantor of insured portfolio value. Second, the crash made manifest the latent danger large amounts of insured assets pose for market liquidity and stability.
On the other hand, the crash if anything increased investors' awareness of the potential fragility of the market, and their consequent desire for protection.
The financial community has taken two basic approaches in responding to the revealed problems with synthetic portfolio insurance and the continuing demand for asset protection. One approach has been to "fix" portfolio insurance itself, generally by means of innovative trading structures. The other approach has been to develop new financial products that can provide the protection portfolio insurance promised while avoiding the pitfalls. This chapter examines some of these solutions.
Sunshine trading
When synthetic strategies were first introduced to the financial community, insurance buyers signed up in droves, but no efforts were made to sign up offsetting sellers of insurance. Could insurance-induced order imbalances, such as occurred during the 1987 crash, be reduced by a better match between insurance buyers and sellers? Fischer Black and Erol Hakanoglu have proposed a clearinghouse for insurers, which would explicitly match insurance buyers' and sellers' trades.
Not long after the crash, Robert Ferguson and John O'Brien proposed matching buyers and sellers through stabilizing forwards. Portfolio insurers and their counterparties (market timers and others willing to commit to a limit buy order if the market were to decline or to a sell order if it were to rise) would enter into binding agreements to trade stock index futures at prices agreed upon in advance, if and when the market reached specified levels. These forward contracts would, in effect, pre-sell the trading needs of insurers at pre-negotiated prices. If the market experienced a major decline, the contracts would provide the insured portfolio with the specified protection. Such protection would not require dynamic hedging, or its associated trading, so it would have no impact on the market in periods of price declines (or price rises, for that matter).
A more indirect approach would be to advertise insurers' intentions, what is known as "sunshine trading." In his 1991 book, "Financial Innovations and Market Volatility", Merton Miller noted:
"Many observers believe, with some justification, that massive liquidations by portfolio insurers overwhelmed the normal marketmaking capacities of both the New York Stock Exchange and the Chicago index futures and options exchanges. The selling pressure was further intensified, some believe, by the public's inability at the time to distinguish adequately between 'informationless' trades by portfolio insurers and those of informed investors."
Mr. Miller asserts pre-announcement of insurance sales during the crash might have encouraged the prompter participation of buy-side traders.
Writing in the 1990 American Economic Review, Gerard Gennotte and Hayne Leland demonstrated insured assets amounting to 5% of the market can set off a market decline of 30%, if the market is completely unaware of insurers' trading intentions. If, on the other hand, the market is fully informed of insurers' intentions, Messrs. Gennotte and Leland predict a drop of only 1%. They recommend wider dissemination of knowledge about hedgers' intended actions through pre-announcement of trading requirements.
Steve Wunsch's proposal for sunshine trading aims to reduce the destabilizing impact of insurance trading through advertising insurers' intentions. Under this scheme, insurers voluntarily would announce their intentions to trade. In a similar vein, Sanford Grossman suggests insurers be permitted to publicize their trading needs at various market levels.
As insurers are "informationless" traders, they arguably have nothing to lose by revealing their trading plans. And if insurers' trading intentions were fully anticipated, market timers and other sellers of insurance could commit more resources to accommodating their trades. Its advocates claim sunshine trading could stabilize the market by curtailing unanticipated demands for liquidity. They point to the U.S. Treasury auctions as an example of successful pre-announced trading.
Some critics, however, maintain sunshine trades would attract front-runners. Front-runners trade in anticipation of large-volume trades that have the potential to change prices; by buying before an expected large purchase, for example, they may be able to reap a profit if the purchase raises prices even higher. Front-runners can destabilize markets when they trade in tandem with trend-following strategies such as synthetic portfolio insurance.
Anat Admati and Paul Pfleiderer, in the 1991 Review of Financial Studies, examined sunshine trading in the light of a rational expectations model with three groups of traders: liquidity traders who pre-announce trades, liquidity traders who do not pre-announce, and speculators with varying levels of information.
They find that, when information is heterogeneous and speculative trading is not costless, sunshine trading encourages the entry into the market of speculative traders in times of greater demand for liquidity. The larger the size of the pre-announced orders, the higher the proportion of speculators who will enter the market and trade, providing liquidity.
In 1992, Mr. Wunsch put his sunshine trading concept into practice with the launch of the Arizona Stock Exchange. Participants in this electronic "single-price call market," all institutional investors, log onto the exchange's computer for its daily hour of business. In that time, they reveal their trading intentions, listing the stocks and the prices at which they wish to buy and sell. They can then observe the orders of other participants and reconfigure their own orders as they see fit. At closing, the computer matches as many trades as possible.
Sunshine trading, by revealing the demand for insurance, could reduce problems related to information aggregation and may encourage portfolio insurance counterparty trading. To the extent it encourages investors to take the other side of insurance trades, sunshine trading may ameliorate another major problem highlighted by the 1987 market break - the failure of portfolio insurance strategies to perform as expected.
The chaotic conditions during the crash (to which portfolio insurance itself contributed not a little) made it impossible for many portfolio insurers to move from equities into cash positions in time to prevent substantial violations of their floors. The decade since the crash has seen the emergence of a number of new financial instruments and strategies designed to offer more dependable protection of equity portfolio values. Below, we look at some examples of what might be called the "sons" of portfolio insurance.
Supershares
Leland O'Brien Rubinstein's Mr. O'Brien (quoted in Forbes, Feb. 15, 1993) admits the stock market crash of 1987 and its aftermath was "a very difficult time for our firm. But we felt ultimately that demand for hedges would persist." In 1992, LOR brought to the public exchanges a product that offered more solid downside protection for insurers and less instability for markets. Building
on Nils Hakansson's concept of a superfund, LOR's "SuperTrust"offered exchange-traded mutual fund shares that could be broken out in several ways according to investors' desires for capital gains, downside protection or current income.
The idea of divisible equity shares had been marketed previously in the form of Americus Trust units, which were available for some five years beginning in the mid-1980s. Americus Trust units were finite-life instruments redeemable into shares of the underlying common stock and fully collateralized by common stock held by the trustees. Purchasers of units, however, could choose to convert their units into either PRIMEs or SCOREs. PRIMEs offered income in the form of dividends on the underlying stock, plus varying degrees of participation in the stock's appreciation over the terms of the trust. Provided the underlying share value at termination did not exceed a pre-determined termination claim value (equivalent to a strike price), PRIME purchasers received a full share of common for each PRIME; if the value at termination exceeded the termination claim, purchasers received a fractional share equal to the ratio of the termination claim value to the closing price of the common. SCOREs entitled their purchasers to all of the capital appreciation on the underlying shares over and above the termination claim.
Whereas the underlying securities for PRIMEs and SCOREs were the shares of a small number of individual corporations, LOR's 'SuperTrust' rested on two broad-based market funds. Shares in the trust, which were fully redeemable, were convertible into two "SuperUnits" traded on the American Stock Exchange. One unit, the "Index SuperUnit," represented a share of an index fund based on the S&P 500; the other, the "Money Market SuperUnit," a share of a money market fund. Both had a three-year life and earned the dividend and interest payable on the underlying assets.
Each unit could in turn be divided into two complementary "SuperShares" that were listed on the Chicago Board Options Exchange. Complementary shares of a unit could be traded separately or recombined into the unit and sold on the Amex or redeemed. The sum totals of their payoff patterns equaled the total payoffs of the underlying assets, and the shares were fully collateralized by the assets in the funds.
The SuperTrust allowed investors to pick and choose between shares in order to emphasize income, equity market exposure or protection. For example, the index unit split into a "Priority SuperShare" and an "Appreciation SuperShare." The former received the dividends earned by the unit plus the total capital gains at the end of its life of up to 25% of original value. The latter earned the capital gains in excess of 25%. Appreciation SuperShares were thus the equivalent of a three-year call option on the S&P 500 index, rising in value when the market rose above the strike price (index appreciation of 25%), but with the possibility of expiring worthless after three years if the index did not appreciate by more than 25%.
The Money Market SuperUnit broke down into a "Protection SuperShare" and an "Income and Residual SuperShare." The former received the capital value lost by the index unit after three years, if any, up to a maximum of 30%. The latter received all interest due the money market unit, plus the residual of its final value after the protection share was paid off.
Protection SuperShares thus offered downside protection, acting as a three-year put option on the S&P 500 index, and appreciating in value when the market fell below the strike price (the starting value of the index). Of course, this option also could expire worthless. But Mr. O'Brien advised in an April 1993 marketing letter that it "could be an important hedging security for your general equity portfolio."
Because they were based on market indexes, SuperShares provided a more appropriate vehicle for overall portfolio management than PRIMEs and SCOREs. Furthermore, the addition of the money market component introduced the ability to hedge against actual market declines, which SCOREs and PRIMEs alone could not provide.
SuperShares also offered advantages over synthetic portfolio insurance. Exchange listing, because it fully reveals prices, hence demand, should encourage liquidity. SuperShare prices were determined by the competition of investor demands. Investors desiring protection against market declines would have purchased protection shares; others, looking for exposure to an index fund, would have bought appreciation shares. If the demand for protection rose, perhaps as the result of market pessimism, the cost of the protection shares also would rise. Share prices thus should have revealed fully the demand for and the cost of protection.
Price transparency, exchange listing, and the unit sizes of shares (small enough to appeal to retail investors) should have encouraged the participation of traders willing to provide the liquidity needed by institutional hedgers. This in turn would have made markets less susceptible to the problems of instability posed by synthetic insurance. Stability also would have been enhanced by the fact that, beyond initial purchase of the shares, no further trading was required to achieve protection over a given horizon, even in volatile markets.
The ultimate value of LOR's SuperTrust for investors desiring to hedge against market declines depended on its success in attracting enough speculative investors and active professional traders to ensure secondary market liquidity. Unfortunately, what SuperShares failed to offer was simplicity. And, indeed, their initial reception and subsequent performance were less than royal. LOR had planned to launch with $2 billion in initial subscriptions, but ended up settling for $1 billion in commitments, mainly from large institutional investors. The SuperTrust was not renewed after its initial three-year run.
Options reborn
Publicly traded options offer numerous advantages over the synthetic strategy when it comes to providing protection. They do not require selling into a falling market, as portfolio insurance does. Real put options are thus not susceptible to replication failures because of volatile or discontinuous markets.
Insurance through publicly traded options offers another advantage over dynamic strategies: trading intentions are not masked. The market is thus not destabilized by unanticipated insurance trading demands. Because the selling pressure associated with puts is fully revealed, the puts are priced at a level that attracts natural partners. As Mr. Miller asserts in the 1992 Journal of Applied Corporate Finance:
"The potentially destabilizing impact of portfolio insurance is much reduced when carried out with index options. .*. *. With exchange-traded puts, the bearishness in portfolio insurance would make its presence known immediately in the market prices and implicit volatility of the puts."
But dynamic hedging came about in part because portfolio protection via publicly traded options faced insurmountable obstacles. First, exchange-traded options were only available for certain standardized strike prices and expirations, and their time horizons were fixed and generally quite short. While one could have used a series of publicly traded short-term options to provide protection over the long run, one would not know the cost in advance, as it would depend on market volatility at the times the options were rolled over; the ultimate cost could be substantial.
Second, the maximum position limits imposed by the Securities and Exchange Commission reduced the usefulness of exchange-traded options to large institutional investors. Gary Gastineau, in a 1992 Journal of Portfolio Management article, suggests insurers need not have traded stock and futures during the 1987 crash if they had been permitted to have large positions in listed options: Long puts or calls would have cut their stock exposure automatically, and given them time to analyze the risk of the market - without the necessity to trade. An efficient option market with no position limits might have attracted portfolio insurance buyers and sellers to a trading and risk management mechanism designed to price and redistribute the impact of market volatility.'
The shortcomings of synthetic portfolio insurance and exchange-traded options, made evident by the 1987 crash, opened the door for the development of an array of customized, over-the-counter vehicles to meet institutional investors' hedging and other portfolio management needs. Taking its cue from OTC customized interest rate, currency and commodity contracts (pioneered in large measure by the Europeans), the U.S. financial services industry has, in the decade since the crash, developed and marketed a wide range of OTC equity derivatives.
Institutional investors who do not see what they need on the menu of exchange products increasingly are joining the stampede to the OTC market where, it seems, they can achieve just about any desired payoff pattern (or combination of patterns), as long as a counterparty can be found to provide it.
One of the most popular equity products suitable for use in insurance strategies has been the OTC option. This is a privately negotiated contract between two parties - the option writer (usually an investment bank, bank subsidiary or broker-dealer) and option buyer (typically a large institutional investor). Because the counterparties design the option to meet their own specific needs, it can be based on any agreed upon underlying stock, stock portfolio or index; strike price; maturity date; and exercise style (European or American). OTC options can be tailored to the investor's particular exposure and protection requirements and offer maturities and capacities not available on the listed options markets.
Further elaborations on the simple option concept are provided by so-called "exotic options," including barrier options, average rate options, relative performance options and lookback options.
The payoff on barrier options is contingent, not only on the underlying security's price at exercise, but on that price's achieving or not achieving a specified level before expiration; a "knock-in" option may reach expiration in the money, but nevertheless expire worthless if the underlying security fails to pass a specified barrier over the course of the option's life, whereas a "knock-out" option will become worthless if the underlying security passes a specified barrier.
The payoff on an average rate, or "Asian" option depends on the average price of the underlying asset over the specified period. Both barrier and average rate options generally are less expensive than their more orthodox counterparts because they offer less opportunity of payoff or a more limited payoff.
Relative performance and lookback options are generally more expensive than regular OTC options because they allow their purchasers more possibility of payoff. The relative performance option, for example, pays the difference between two underlying assets, whether stocks, stock baskets, or indexes; even if both decline (or rise), the option holder will receive a payoff as long as relative performance turns out as expected. A lookback option allows the purchaser to choose the option's strike price on the basis of the underlying asset's prices over the option's life.
OTC options suffer from several disadvantages relative to listed options. In the absence of a secondary market, OTC options are substantially illiquid and more difficult to value. They also are customized instruments, hence more expensive (although increasing competition among financial intermediaries has driven down prices of those options with the most common specifications). Finally, since there is no exchange clearinghouse providing a financial guarantee, holders of OTC options face the risk of counterparty default.
Expanding the listed option menu
Spurred by the mushrooming volume (and profits) in OTC markets, the exchanges themselves began in the late 1980s and early 1990s to offer options that were more suitable to institutional investors' needs. Ironically, the Amex introduced three-year, European-style options on the Institutional Index the morning of Oct. 19, 1987. And in early November 1987, the CBOE began trading options on the S&P 500 with a two-year maturity. In October 1990, the Option Clearing Corp. began to issue LEAPS - Long-term Equity AnticiPation Securities - two-year puts and calls on a select number of individual securities as well as the S&P 100, the S&P 500 and the MMI. These basically were aimed at individuals and speculative traders, however.
In early 1993, the CBOE announced plans for "flexible options" geared to institutional investors (initial transactions of at least $10 million of notional principal on the S&P 100 or 500). FLEX options allow customization of contracts for the underlying index (S&P 100 or S&P 500), expiration date (up to five years), strike price, exercise style (American, European, or capped European), and settlement value (expiration-day opening, closing or average price). Like other exchange-traded instruments, FLEX options enjoy the credit guarantee of a clearinghouse (the Option Clearing Corp. in this case); price transparency; and an established secondary market.
Purchase of puts, whether exchange-traded or OTC, requires payment of a premium up front, whether or not the option is eventually exercised. The fallacious assertion made for synthetic portfolio insurance - that it would offer comparable protection at little or no cost - has more lately been heard on behalf of option "collars." "Zero-cost" collars became particularly popular in early 1991. Estimates of the total stock value covered by it in that year range as high as $25 billion.
With a collar, the investor purchases an out-of-the-money index put option and pays for it by selling an out-of-the-money call option. The strike price of the put option serves as the floor for the portfolio's value, while the strike price of the call option represents a "cap" on the portfolio's value. A well-designed collar may indeed cost nothing at the time of purchase. As with portfolio insurance, however, its true cost becomes apparent only after the fact. If the market rises beyond the cap, the opportunity cost is the performance gain the portfolio could have made but in which it is now unable to participate. Complete surrender of returns beyond the cap might turn out to be a substantial cost to pay for a "zero-cost" collar.
In addition to OTC and exchange-listed options, the past decade has witnessed tremendous growth in other vehicles designed to offer option-like payoff opportunities, including synthetic warrants, swaps, and option-embedded bonds, or "embeddos." These vehicles are suited to investors desiring to speculate on market movements, to attain index-like returns at low cost, or to achieve otherwise unattainable exposures to certain markets. They also can be used to hedge against downside moves, hence may play a role in certain portfolio insurance strategies.
(contd. in Part 2)
