The Crash of '87: Was it Expected? The Evidence from Options Markets.

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Attempts to explain what caused the stock market crashes around the world in October, 1987 have suffered from the paucity of major economic developments occurring around that time that could have triggered the crashes. Shifting expectations regarding monetary policy, foreign investors' fears of a dollar decline, increasing riskiness of assets--none of these appeared major enough, if at all, to explain the magnitude of the crashes. The purpose of this project is to determine whether the climate of investor expectations before the crash was such that these expectations, in and of themseleves, could have been a major factor in causing the crash. Transactions data for stock-option futures traded on the Chicago Mercantile Exchange will be analyzed to investigate the nature of these expectations. These data should be especially informative in this regard because, theoretically, there should be a close relationship between option prices and underlying asset prices. For example, a significant probability of a market crash will lead to relatively high prices for put options that pay off only when the stock market falls substantially. This project will glean new insights from the options data about expectations of a market crash. This research is important because it should corroborate or discredit the hypothesis that the crash was a self-fulfilling prophesy--i.e., that the market crashed because investors simply viewed it as over valued and expected a crash.