Financial MVE220

Black Swans and Applied on the 1987 bank crisis

Authors: William Danielsson [email protected] 941204-6576

Matilda Persson [email protected] 951015-6061

Examiner: Holger Rootzen´

Study Period 4, 2018 1 Introduction 1.2 Method

First, for the authors to get a broad under- has become more standing of the subject a small literature and more important and widely implemented search on Google was made. Thereafter, a within several areas. It is useful in bio-medical more thorough literature review was made to studies, in machine-learning, for quality con- fully understand the subjects and the time- trol, and not at least within insurance and line of the bank crisis in 1987. One ex- finance. Statistical tools can be used to map pert within the area of Black Swans and An- biological phenomena, make predictions from tifragility was identified, and this knowledge data, ensure evaluate quality parameters, and was used to further dig into the subjects. especially to estimate and future trends within finance. Last, some free reflection was done between the authors of this report to make sure all con- Black Swans and Antifragility are two con- cepts and theories was understood correctly. cepts within financial risk that has have (and Some final thoughts of the authors was also will probably continue to have) massive im- generated. pact on statistical finance. These concepts were founded by in the beginning of the 21th century and has since grown in popularity. 2 Black Swans

Short said are Black Swans unforeseen events A black swan is an event that is unpredictable, and Antifragility is about getting stronger has extreme impact and can be explained af- from pressures. The ideal scenario within fi- terwards to seem less random than it was [1]. nancial statistics is when unforeseen events, There are several historic examples of Black Black Swans, make the financial system Swans within technology, science, culture and stronger. For example should financial cri- business. But let’s start from the beginning. sis not hurt the system, but make it stronger. The concept of Black Swans was, as said, Specially interesting is to see how a real finan- founded by the Professor in Science of Uncer- cial case can apply these two concepts and tainty Nassim Nicholas Taleb in 2007, when to investigate what impact these theories can he published the book with the same name [1]. have in the future. To gain a deeper under- The name, Black Swans, originate from the standing for Black Swans and Antifragility fact that Europeans thought that all swans the bank crisis in 1987 has been chosen to be were white in the end of the 1600-century. All investigated and the concepts are applied to swans they had seen were white and there was this case. no reason to believe something else existed. After a travel to Australia, though, some ex- perienced black swans. This discovery forced Europeans to change their picture and accept 1.1 Aim that swans could be both white, and black. Thereof the name of Black Swan.

This report aims to give the reader an intro- As mentioned before there are several exam- duction to Black Swans and Antifragility, it ples of Black Swans in history. Think about will not be a complete investigation of the the terrorist attack 9/11. The introduction subjects but more of a summary. This report of computers. The art of printing. Economic also aims to present the course of event of the crisis. All these are events that were unpre- 1987 bank crisis and apply the two concepts dictable, but seem obvious, and perhaps even of Black Swans and Antifragility on this real inevitable, after they happened. They have case. also had a massive impact and changed how

1 we view things. this is where an event can have significant impact. Black Swans are defined by three characteris- tics defined below [1]. Black Swans can not be predicted. Unex- pected events, both positive and negative, will The event is unpredictable. The reason continue to happen and change our perception why Black Swan events are not predicted of the world. New theories will continuously before they occur is, according to Nassim evolve when new data is available. The beauty Nicholas Taleb, that humans often focus too with this concept is that the future can not be much on what we know and forget to take estimated to full and therefore Black Swans into consideration what we do not know [1]. will continue to pop-up. This is about the subject of scalability. Gener- ally, humans are too quick to scale knowledge without considering the risk with interpolat- ing outside the boundaries. 3 Antifragility

The event has extreme impact. The sec- ond characteristic is that of the large conse- Consider a daily situation; a package with quences the event has. The consequences can fragile items are sent. Such a package is nat- be either positive or negative. Examples of urally handled with caution, to avoid damage positive Black Swans are the invention of the to items. What is the exact opposite of such art of printing or the introduction of comput- a situation? At first thought, words like re- ers. Negative Black Swans can be the terrorist silient or robust come to mind. However, that attack 9/11 or economic crises. is akin to calling the opposite of positive neu- tral. Instead, an antonym to fragile, it is Explanations describing the event’s expected that, in addition to being unbreak- predictability are developed after the able, it should benefit from shocks, stress and occurrence. All theories are based on ex- a wide array of trauma. In lack of an existing perimental data of past events. When a new, word describing the phenomenon of reverse- unpredicted event (a Black Swan) happen new fragility, we may call it ’’. A concept theories based on this new data is developed. introduced and widely discussed in [2]. These theories often also find indicators that the event was to happen, and that the event Antifragile things benefit from shocks; when should have been predicted. exposed to , , disorders, and stressors they thrive and grow [2]. In What is then the effect of Black Swans? It comparison to simply resilience; the resilient depends on if in ”mediocristan” or in ”ex- resists shocks and stays the same - the an- tremistan” [1]. When in ”mediocristan” if tifragile gets better. The antifragile embraces one measure is added to a large sample of randomness, , and gain when ex- experimental data, it will not significantly posed to errors. Aside from, as an exam- change the total. This is true for most evolu- ple, the economic systems, the human body, tionary phenomena, such as human weight. If which may benefit from stressors and volatil- one person’s weight is added to a large sum of ity, there are human-made objects like finan- weight (even if adding the heaviest person on cial contracts designed to benefit from market earth) it will not significantly change the sum volatility. of weights. If in ”extremistan”, looking at extremes, one measure can in fact change the The antifragility of some comes necessarily total. For example, if studying the worth of at the expense of the fragility of others [2]. a sample of people and add the worth of the Antifragility can be examined from a collec- wealthiest person on the earth, he/she will tive perspective, e.g. a natural organism with represent a large portion of the total wealth. many parts or a global economy divided into It is within extremistan we find Black Swans; several local economies. In a collective, the fragility of some parts is often necessary for

2 the well-being of the system as a whole or from this as to avoid it happening again? The others. The benefits from a failure of a frag- antifragility of some parts at the expense of ile part are usually transferred to the others, fragility of others. rather than the fragile part itself. If a local restaurant shuts down in a local region, the Similarly, antifragility and fragility can also be rest of the restaurants in the region may ben- seen in a company itself. Whether a company efit: not only in reduced competition but also tries a new product for the market, decides the opportunity to learn from the errors of to scale into a new territory, or anything else the ”sacrificed” local restaurant. of risky , there is prone to be some fail- ures. Failures that may result in severe costs, The antifragile is not completely oblivious to such as cash and time. However, it also facil- errors [2]. For the antifragile, the harm from itates the company with knowledge of what errors should be less than the benefits. Errors did not work, and why it did not work - to should not be of such degree that it completely avoid future, similar mistakes. destroys the system or unit, but instead can help prevent larger calamities in the future. Worthy of note is that an economic system 4 The crash 1987 is not necessarily antifragile. Consider glob- alized economic systems that operate as one, this means that errors can spread and com- The market crash of 1987 occurred on the pound throughout the whole system rather 19th of October 1987, with key-events leading being confined to a single unit. up to the market crash happening in the week before. The crash led to a major economic Illustrating a case of gaining from disorder, systemic shock. Prices of many financial as- sets tumbled, and market functioning was ”...Sweden and other Nordic coun- impaired. The crash exposed weaknesses in tries experienced a severe reces- the trading systems. Several, major factors sion at the end of the cold war, have been attributed to the crash: difficulty around 1990, to which they re- in gathering critical information for investors, sponded admirably with a pol- record high margin calls, and program trad- icy of fiscal toughness, thus effec- ing strategies. The Federal Reserve bolstered tively shielding them from the se- marketing conditions by liquidity support. A vere financial crisis that took place main source of inspiration for the events sur- about two decades later.” rounding the crash of 1987 is given by [4], - Nassim Nicholas Taleb due to its objectivity and claims, discussions [2, Chapter 7, Sweden and the supported by references. Large State] Leading up to the market crash, there had been rising interest rates globally, with grow- Sweden experienced a housing bubble that de- ing U.S. trade deficit, and a decline in the flated during 1991 and 1992, with subsequent value of the dollar. There were concerns about policy of fiscal toughness implemented by the inflation and higher interest rates in the U.S. Swedish government, see e.g. [3]. as well. In addition, there were indications of an overvalued market due to price increases The concept of antifragility can be applied outpacing earnings growth [5]. The financial in the world of entrepreneurship. Starting a market also saw an increase in program trad- business is a risk endeavor, with the poten- ing strategies, especially with portfolio insur- tial of failure. However, alluding to previous ance and index strategies. Roughly, discussions about fragile and antifragile parts program trading strategies were a computer in a collective, the failure of some businesses program set up to quickly execute trades of a facilitates knowledge and expertise for others. number of stocks, e.g. of a stock index, when What did not work? What can be learned certain conditions were met.

3 In the week before the crash, a couple of major expires - a margin call [11]. events took place. Due to a legislation regard- ing the elimination of tax benefits with finan- When adjusting the margin accounts, margin cial mergers, stocks’ values were reassessed as exchanged between declining margin accounts a result, as odds of companies being takeover and gaining margin accounts, the gaining mar- decreased [6]. gin accounts only got credited after declin- ing accounts posted margin. When, and how Anxiety among institutions and investors in- many times calls for margin happened varied, creased, and it led to a heavy selling at the but always happened at the end of the day. end of the 15th [7]. As to sharp price movements on Oct. 19 on futures contracts, the margin calls resulted in Markets continued to decline on the 16th, with record highs. Difficulty to immediately meet increased price discrepancy between the value the margin calls could likely have prohibited of the stock index in the futures markets and gaining margin accounts for entering new po- value of the stocks on the NYSE (New York sitions. In addition, the high margin calls Stock Exchange). By the end of Friday, with could have contributed to stress in meeting S&P 5001, fallen over 9% over the week. One the margin calls. of the largest one-week declines of a preceding couple of decades [8]. Notable program trading strategies during the market crash was portfolio insurance and in- The day of the crash, Monday the 19th, dex arbitrage. Portfolio insurance consisted of started with a high sell to buy ratio of or- computer models computing optimal stock-to- ders on NYSE. Significant selling continued cash ratios at various market prices. A strat- throughout the day, with between 18% to 23% egy designed to protect individual investors declines for the Dow Jones Industrial Aver- from losses. A theory is that simultaneous age, S&P500, and Wilshire 5000. In addition, use of computer models could have made the S&P500 futures markets declined 29%. The fall a systematic event, with a snowball effect. next day, Tuesday the 20th, NYSE rebounded The effect of program trading is a question at the open, despite an overnight decline in with divided opinions, however. foreign stock markets [9]. Later afternoon there was a sustained rise in financial mar- Lastly, the lack of information and news could kets as corporations announced stock buyback have led to uncertainty, anxiety and a herd- programs to support demand for their stocks like behaviour. During the sudden and fast [10]. change of prices, there was a lack of informa- tion about current market conditions. Certain Factors contributing to the crash is difficult stocks not being open for trading during the to precisely pinpoint. Three widely referenced crash, rumors about potential market closing and discussed factors include rising margin added confusion and anxiety to the situation. calls, program trading strategies, and a com- With uncertainty and investor seeking to sell bination of market psychology and difficulty due to market prices rather than news, led to of obtaining information. a herd behaviour as reported in [12].

When investors entered into a contract in fu- tures markets, they were also required to post a portion of the value of that contract, the 5 Discussion/Conclusion margin, in an account with the broker. If the investor’s position declined due to the market, In this section the theories around Black the margin account would be debited accord- Swans and Antifragility will be discussed and ingly, and the investor would generally have to applied to the market crash in 1987. infuse additional margin into the account to be able to meet obligations when the contract From a quick glance, the financial crash in 1An American stock market index based on market capitalizations of 500 American companies.

4 1987 can be seen as a Black Swan in two ways. experience sudden large rises. Measures ap- First was the unforeseen crash on Monday proved by the SEC following . October 19, 1987 one Black Swan. Second was the extremely fast recovery of the stock The theories about Black Swans and An- market another. tifragility can not explicitly be used to reduce future risks. Thought, when Black Swans oc- The crash itself was quite unique in its appear- cur, new data gets available and new theories ance. Normally in market crashes only stock about the root-cause is developed. This can prices fall, but the futures stay quite stable. help predict similar Black Swans in the future, In the case of the crash in 1987, thought, both although new situations will always occur and stock markets and futures fell strongly. Some be impossible to predict. theories about why this happened this time has evolved after the crash and it has strongly affected the way we look at crashes today. 6 Reading guide For these reasons can both the crash itself and the fact that both stocks and futures fell simultaneously be classified as Black Swans. If the reader in interested in immersing him- self in the concept of Black Swans and An- In terms of the recovery, much was due to the tifragility, we can recommend the author Nas- Federal Reserve liquidity assurance. It was an sim Nicholas Taleb, who is the founder of unforeseen event that they did so, and it had both of these concepts. Specially the books big impact on the crash. For these reasons ”The Black Swan - The impact of the highly both the recovery and the event of assuring improbable” and ”Antifragile: Things That liquidity can be classified as Black Swans. Gain From Disorder” can be recommended.

An important factor in the case of Black Mon- For further reading about the bank crisis in day was the usage of program trading strate- 1987 the article ”A Brief History of the 1987 gies. At the time, a system was facilitated on Stock Market Crash with a Discussion of the the NYSE to enable program trading. It was Federal Reserve Response” by Mark Carlson automatic, and constructed to handle large can be recommended as a good starting point number of trade orders. Due to the immense with an in-dept discussion about the crisis. volume of trading orders on Oct. 19, many systems were reported to be overwhelmed. In some cases, trade executions were reported References more than an hour late, causing confusing among traders [13]. The system in place for program trading at that time can be consid- [1] N. N. Taleb, The black swan - the impact ered a fragile part of the economic system at of the highly improbable (The Random that time. House Publishing Group, 2007).

In response after Black Monday, a number of [2] N. N. Taleb, Antifragile: things that gain protective mechanisms were enforced into the from disorder (The Pub- economic systems. Partly by the introduc- lishing Group, 2012). tion of trading curbs [14] and circuit breakers [3] P. Englund, “The swedish 1990s bank- [15]. Trading curbs is a temporary restric- ing crisis”, tion put on program trading when dramatic [4] M. Carlson, “A Brief History of the 1987 price movements or volatility occur. For a cer- Stock Market Crash with a Discussion of tain security or market, the trading may be the Federal Reserve Response”, (2006). halted or certain sales can only be executed [5] A. Murray, “Fed’s New Chairman Wins on an uptick. Circuit breakers are halts in a Lot of Praise On Handling the Crash, tradings enforced when prices hit pre-defined ( 1987, Nov. 25, huge intraday drops, or if a company’s share page 1)”,

5 [6] “U.S Securities and Exchange Commis- [11] N. Brady, “Presidential Task Force on sion, Annual Report 1988”, Market Mechanisms (1988): Report of [7] N. Brady, “Presidential Task Force on the Presidential Task Force on Market Market Mechanisms (1988): Report of Mechanisms., Study VI, page 23-24.”, the Presidential Task Force on Market [12] R. J. Shiller, “Investor Behavior in the Mechanisms., page 21.”, October 1987 Stock Market Crash: Sur- [8] “The Day the Dow Fell: Brokers Trade vey Evidence, Chapter 23”, Stocks, Fists; Bulls and Bears Are [13] “Presidential Task Force on Market Joined by Ducks and Chickens, (Wall Mechanisms (1988): Report of the Pres- Street Journal 1987, Oct 19, page 15)”, idential Task Force on Market Mecha- [9] N. Brady, “Presidential Task Force on nisms, Study III, page 21.”, Market Mechanisms (1988): Report of the Presidential Task Force on Market [14] Trading curb, https : / / www . Mechanisms, page 36-40”, investopedia . com / terms / t / tradingcurb.asp. [10] N. Brady, “Presidential Task Force on Market Mechanisms (1988): Report of [15] Circuit breaker, https : / / www . the Presidential Task Force on Market investopedia . com / terms / c / Mechanisms, page 41.”, circuitbreaker.asp.

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