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Stock market crashes: what have we learned from October 1987?

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  • Peter Fortune
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    Abstract

    Perhaps the most widely held view of the Crash of 1987 is the Cascade Theory: the Crash emerged from the interaction of stock prices with new financial strategies such as program trading and portfolio insurance, which use new financial instruments including stock index options and futures. According to this view, a decline in stock prices initiated by fundamental factors led to an overreaction in stock index futures prices, due largely to portfolio insurance. This, in turn, created a negative spread between stock prices and futures prices, hence encouraging a further decline in stock prices through index arbitrage. In short, a moderate decline exploded into a severe Crash because of the existence of new financial instruments. ; This article concludes that while the reasons for the Crash are complex and cannot be disentangled, the markets for new financial instruments performed correctly during the Crash. The market that failed was the stock market itself. Trading mechanisms were not able to deal with the flood of selling orders, and the long delays in information about the actual prices at which stocks were trading created "stale prices," which were the primary reason for the large discount that emerged in stock index futures. These discounts acted as a signal for further sales, thereby creating pressures for further stock price declines. The article examines the efficacy of policy proposals designed to discourage future crashes, among them trading halts and margin requirements. It is argued that these are not likely to have a significant effect on the potential for crashes, and that they have the potential to exacerbate the problem.

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    File URL: http://www.bostonfed.org/economic/neer/neer1993/neer293a.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1993)
    Issue (Month): Mar ()
    Pages: 3-24

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    Handle: RePEc:fip:fedbne:y:1993:i:mar:p:3-24

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    Keywords: Stock market;

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