History of 1987 Stock Market Crash
On October 19, 1987 the stock market in the U.S. along with the associated futures and options market crashed with the S\&P 500 stock market index falling about 20 percent (A considerably large percentage fall). The causes of concern were the severity and swiftness of the market decline and the weakness of the trading systems as they were stretched and came close to breaking in extreme conditions. This was of course exuberated by the decline in the prices. There was also a considerable lack of uncertainty in obtaining information.
This article gives a brief on the background of the crisis, the events that led to it and the actions taken by the Federal Reserve to help calm down the markets and restore investor sentiment.
Firstly let us look at the market conditions that prevailed before the crash. Prior to the crash the stock market had posted very healthy gains. Price increases outpaced earnings growth resulting in over-valuation and inflated price-to-earnings ratios. Two other factors that contributed to price trend increase had been the influx of new investors notably pension funds and favorable tax treatments given to finance corporate buyouts. The market was also employing the use of program trading strategies. There were broadly two strategies that were used: Portfolio Insurance and Index Arbitrage. Very briefly a program trading strategy is one that employs computer models to trade large amounts of stock when certain conditions have been met.
Portfolio insurance method involves computing optimal stock-to-cash ratios at various market prices and limit losses investors face in a declining market. By buying stock index futures in a rising market and selling them in a falling market, portfolio insurers could provide protection against losses from falling equity prices without trading stocks. As portfolio insurers did not continually update the analysis about the optimal portfolio of stock and cash holdings there were concerns that this could lead to many investors selling stocks and futures simultaneously.
Index Arbitrage strategies involve exploring the arbitrage opportunities between the value of the stocks in an index and the values of the stock-index-futures contracts.
In the months that led up to crash the macro-economic outlook became less certain with interest rates rising globally. This increase in interest rates was due to a growing U.S trade deficit and a decline in the value of the dollar leading to concerns about inflation.
The timeline of the crash is as follows:
Wednesday, October 14 – Friday October 16 1987
On Wednesday two events precipitated the decline in the stock market. The first was the filing of legislation by the Ways and Means Committee of the US House Of Representatives to eliminate tax benefits associated with financing mergers. Second the Commerce Department announced that the Trade Deficit for August was notably above expectations. This resulted in a decline in the value of the dollar and increase in the interest rates. On Thursday the decline continued which was primarily attributed to anxiety especially among the pension funds and institutional investors. The decline continued on Friday as anxiety was augmented by technical factors, primarily relating to many stock index options expiring on Friday and the difficulty into rolling over the positions into new contracts for hedging purposes. More investors sold futures contracts as a hedge against the falling stocks which led to a price discrepancy between the value of stock index in the futures market and the value of stocks on the NYSE, which was taken advantage of by Index Arbitrage traders causing a further downward pressure on the NYSE. By the end of the day on Friday, markets had fallen considerably, with the S\&P 500 down over nine percent for the week which left the Portfolio Insurers with an overhang and the models suggested they should sell more stocks or futures contracts. The futures contracts were already experiencing a heavier than usual volumes.
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