Portfolio Insurance and October 19th

Formally, most portfolio insurance programs attempt to replicate a (long-term) put option. For further specifics, see Rubinstein M. Leland H. , “Replicating Options with Positions in Stock and Cash,” Financial Analysts Journal (July/August 1981).

Some critics, failing to understand the nature of the dynamics required to replicate a put option, have incorrectly characterized the dynamics as “buy high, sell low.” For a further discussion of this and other misperceptions, see Leland H. , “10 Myths About Portfolio Insurance,” Intermarket (January 1986), pp. 32–34.

A “long” futures position (competitively priced) will be the equivalent of owning the basket of stocks and borrowing at the (3-month) Treasury bill rate. A “short” position is the opposite. Thus, owning stocks offset by an equal short position in stock index futures is equivalent to owning Treasury bills. This is sometimes termed a “synthetic” Treasury bill.

For a fuller discussion, see Rubinstein M. , “Portfolio Insurance and the Market Crash,” Financial Analysts Journal (January/February 1988). Precise estimation of transactions costs is difficult. Index futures at times were selling for 10–15% less than the spot index. But the spot index tends to lag the true market. After the first two hours of trading, arbitrageurs had difficulty performing their role on the 19th, and therefore transactions costs were considerably higher than in more normal market environments. Harris has recently examined this problem in some detail; see Harris L. , “Contemporaneous Stock Index and Stock Index Futures During the October Market Break,” Finance Working Paper, University of Southern California, February 1988.

These numbers reflect a typical program's performance with the stated objectives. Other accounts with different objectives would result in different numbers.

This number is representative of Leland O'Brien Rubinstein's trading, which was curtailed as an appropriate response to the perceived high costs of trading. Other portfolio insurers may have raised hedges more (or less) aggressively on October 19th.

See reference 4.

This number is based on total volume of $41 billion. Some observers have felt that market-makers' volume should be omitted, since they both buy and sell with the day. Such an adjustment would raise portfolio insurance's proportion of total volume to 20–25%.

Results reported by Terry Marsh to the Berkeley Program in Finance, Santa Barbara, March 29, 1988.

See Shiller R. , “Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence,” National Bureau of Economic Research Working Paper No. 2446, November 1987.

See Leland H. Gennotte G. , “On the Stock Market Crash and Portfolio Insurance,” Finance working paper, forthcoming 1988.

See Black F. , “An Equilibrium Model of the Crash,” paper presented to the Berkeley Program in Finance, Santa Barbara, March 18, 1988.

Shiller , op. cit.

See, e.g., Fama E. , “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance, 25 (May 1970):383–417.

The SEC Report found no causative effect of portfolio insurance on the breaks of September 11, 1986, and January 23, 1987. “The Role of Index-Related Trading in the Market Decline on September 11 and 12, 1986,” U.S. Securities and Exchange Commission, Division of Market Regulation, March 1987.

This technique was used several times, with apparent success. The largest trade was executed on September 12, 1986, for 3,350 contracts of the S&P 500 Index Futures, representing a value of about $350 million. Regulations currently under review limited the extent of information dissemination of these trades.

See Wunsch S. , “Stock Index Futures Commentary,” Financial Futures Department, Kidder Peabody & Co., April 12, 1988.