Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes

In Capital Ideas and Market Realities, Bruce Jacobs sifts through the history of modern finance, from the efficient market hypothesis to behavioral psychology and chaos theory, to determine the cause of recent market crashes. He finds that some investment strategies, especially those based on theories that ignore the human element, tend to self-destruct, and can take markets down with them. Ironically, it is often those strategies that purport to reduce the risk of investing that can pose the greatest danger.

Of particular concern are trading strategies based on the Nobel Prize-winning option pricing model. This model gave rise to option replication, a technique for synthesizing the payoffs to an option by trading between the underlying asset and cash. Replication requires selling as stock prices decline and buying as stock prices rise.

When enough money follows this type of trend-following "dynamic hedging," bubbles and crashes can result. In 1987, trading related to an option replication strategy known as "portfolio insurance" led to the largest crash in U.S. market history. Today, similarly mechanistic trading underlies trillions of dollars in exchange-traded and over-the-counter options and swaps, as well as myriad institutional and retail products designed to provide investors with excess returns at low or no risk.

Capital Ideas and Market Realities uncovers the risks these strategies pose for market stability and investor wealth. The book has also become a lightning rod in the debate over the need for better investment product risk disclosure.

Bruce I. Jacobs is co-founder, co-chief investment officer, and co-director of research at Jacobs Levy Equity Management. He holds a Ph.D. in finance from the Wharton School of the University of Pennsylvania. For 35 years, he has been a major voice for financial transparency. Jacobs has written journal articles and books on equity management and financial crises, including Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes. He is co-author, with Ken Levy, of Equity Management: The Art and Science of Modern Quantitative Investing and Equity Management: Quantitative Analysis for Stock Selection, and co-editor, with Ken Levy, of Market Neutral Strategies. He has spoken at prestigious forums, including those held by University of California, Berkeley, the Wharton School, Institute for Quantitative Research in Finance, CFA Institute, Society of Quantitative Analysts, and New York Society of Security Analysts.