Black Monday is the name commonly given to October 19, 1987. The term should not be confused with other historical events bearing the same nickname.
The Dow Jones Industrial Average is a closely watched stock price index computed by Dow Jones & Co. Founded in 1882, the benchmark index consists of twenty transportation stocks, fifteen utility stocks, and thirty selected industrial stocks, as well as a composite average of all three.
The term liquidity refers to investors’ ability to sell securities like stocks, bonds and future contracts in exchange for cash. Liquidity is a crucial characteristic of fully functioning markets.
The Congressional Budget Office defines asset bubbles as: “An economic development in which the price of a class of physical or financial assets (such as houses or securities) rises to a level that appears to be unsustainable and well above the assets’ value as determined by economic fundamentals. Bubbles typically occur when investors purchase assets with the expectation of short-term gains because of rapidly rising prices. The increase in prices continues until investors’ sentiment changes, in many cases resulting in a sharp decline in demand and in asset prices.”
The 108.35-point decline on October 16 was, at the time, the largest one-day drop in the history of the DJIA, as measured in points.
Various news reports from the time refer to Commerce Department data showing rapid rise in foreign investment in the United States during the 1980s, before Black Monday.
Portfolio insurance is a hedging technique frequently used by institutional investors that employs futures and options to offset movements in prices.
A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Shiller (1988) found that: “An initial price decline starts a vicious circle by causing portfolio insurers to sell, causing further price declines, causing portfolio insurers to sell again, and so on.”
Stock trade transactions settled after three days, while options and futures market trades settled after one day. This cash settlement mismatch forced traders and investors to wait two days for stock trade proceeds to arrive in their accounts even though payments for options and futures trades were required after one day. The mismatched settlement protocols resulted in a virtual standstill in trading after the opening bell on October 20. The Fed’s injection of liquidity later that morning encouraged stock trading to resume.
Panicked selling is typically characterized by market conditions in which a critical mass of participants attempts to sell assets even as buyers are scarce or nonexistent. The lack of willing buyers means prices accelerate downward until willing buyers emerge, or until prices reach zero.
According to the New York Stock Exchange’s current website: “In response to the market breaks in October 1987 and October 1989, the New York Stock Exchange instituted circuit breakers to reduce volatility and promote investor confidence. By implementing a pause in trading, investors are given time to assimilate incoming information and the ability to make informed choices during periods of high market volatility.”
In the wake of the Crash of 1987, option volatility surfaces changed and the probabilities of fat tail (kurtosis)/skew distributions increased, leading to higher prices for out-the-money options. This anomaly implies limitations in the standard Black-Scholes option pricing.
Bernanke, Ben. “Clearing and Settlement during the Crash.” Review of Financial Studies 3, no. 1 (1990): 133-51.
Carlson, Mark, “A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response,” Finance and Economics Discussion Series No. 2007-13, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, DC, November 2006.
Cecchetti, Stephen G., and Piti Disyatat. “Central Bank Tools and Liquidity Shortages.” Federal Reserve Bank of New York Economic Policy Review 16, no. 1 (August 2010): 36-7.
Congressional Budget Office. “Glossary.” Last updated January 2012, http://www.cbo.gov/sites/default/files/cbofiles/attachments/glossary.pdf.
Cowen, Alison Leigh. “Bitter Lessons Gleaned From the Fall.” New York Times, October 22, 1987.
Garcia, Gillian, “The Lender of Last Resort in the Wake of the Crash,” American Economic Review 79, no. 2 (May 1989): 151-55.
Glaberson, William. “The Market Plunge; Fall Stuns Corporate Leaders.” New York Times, October 20, 1987.
Kohn, Donald L.,“The Evolving Nature of the Financial System: Financial Crises and the Role of a Central Bank,” Speech given at the Conference on New Directions for Understanding Systemic Risk, Federal Reserve Bank of New York and The National Academy of Science, New York, NY, May 18, 2006.
Murray, Alan. “Fed's New Chairman Wins a Lot of Praise On Handling the Crash.” Wall Street Journal, November 25, 1987.
NYSE Euronext. “Circuit Breakers.” Accessed November 19, 2013, https://www.nyse.com/markets/nyse/trading-info
Shiller, Robert. “Portfolio Insurance and Other Investor Fashions as Factors in the 1987 Stock Market Crash” NBER Macroeconomics Annual 3 (1988): 287-97.
Thrall, Thomas. Interviewed by the Federal Reserve Bank of Chicago.
Written as of November 22, 2013. See disclaimer.