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Underestimation of Portfolio Insurance and the Crash of October 1987

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  • Jacklin, Charles J
  • Kleidon, Allan W
  • Pfleiderer, Paul
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    Abstract

    The authors examine market crashes in the multiperiod framework of Glosten and Milgrom (1985). Their analysis shows that if the market's prior beliefs underestimate the extent of dynamic hedging strategies such as portfolio insurance, then the price will be greater than that which would be implied by fundamentals if the extent of portfolio insurance were known with certainty. Over time, the market learns of the amount of portfolio insurance, and consequently reevaluates the previous inferences drawn from purchases that were erroneously regarded as based on favorable information. The result is that the price falls when the amount of portfolio insurance is revealed. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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    Bibliographic Info

    Article provided by Society for Financial Studies in its journal Review of Financial Studies.

    Volume (Year): 5 (1992)
    Issue (Month): 1 ()
    Pages: 35-63

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    Handle: RePEc:oup:rfinst:v:5:y:1992:i:1:p:35-63

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    Cited by:
    1. Guillermo OrdoƱez, 2012. "The Asymmetric Effects of Financial Frictions," NBER Working Papers 18360, National Bureau of Economic Research, Inc.
    2. C. L. Osler, 2002. "Stop-loss orders and price cascades in currency markets," Staff Reports 150, Federal Reserve Bank of New York.
    3. Avanidhar Subrahmanyam & Sheridan Titman, 2013. "Financial Market Shocks and the Macroeconomy," NBER Working Papers 19383, National Bureau of Economic Research, Inc.
    4. Veldkamp, Laura L., 2005. "Slow boom, sudden crash," Journal of Economic Theory, Elsevier, vol. 124(2), pages 230-257, October.
    5. Devenow, Andrea & Welch, Ivo, 1996. "Rational herding in financial economics," European Economic Review, Elsevier, vol. 40(3-5), pages 603-615, April.
    6. Rudiger, Jesper & Vigier, Adrien, 2013. "Financial Experts, Asset Prices and Reputation," MPRA Paper 51784, University Library of Munich, Germany.
    7. Chen, Joseph & Hong, Harrison & Stein, Jeremy C., 2001. "Forecasting crashes: trading volume, past returns, and conditional skewness in stock prices," Journal of Financial Economics, Elsevier, vol. 61(3), pages 345-381, September.
    8. Sandroni, Alvaro, 1998. "Learning, Rare Events, and Recurrent Market Crashes in Frictionless Economies without Intrinsic Uncertainty," Journal of Economic Theory, Elsevier, vol. 82(1), pages 1-18, September.
    9. Tay, Nicholas S. P. & Linn, Scott C., 2001. "Fuzzy inductive reasoning, expectation formation and the behavior of security prices," Journal of Economic Dynamics and Control, Elsevier, vol. 25(3-4), pages 321-361, March.
    10. Hasbrouck, Joel, 1996. "Order characteristics and stock price evolution An application to program trading," Journal of Financial Economics, Elsevier, vol. 41(1), pages 129-149, May.
    11. Capuano, Christian, 2006. "Strategic noise traders and liquidity pressure with a physically deliverable futures contract," International Review of Economics & Finance, Elsevier, vol. 15(1), pages 1-14.
    12. Madrigal, Vicente & Scheinkman, Jose A., 1997. "Price Crashes, Information Aggregation, and Market-Making," Journal of Economic Theory, Elsevier, vol. 75(1), pages 16-63, July.
    13. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, vol. 110(2), pages 234-263, June.
    14. Joel M. Vanden, 2006. "Portfolio Insurance And Volatility Regime Switching," Mathematical Finance, Wiley Blackwell, vol. 16(2), pages 387-417.

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