Black Monday

Financial Institutions & Markets

Section: B

Maham Nadeem 14L-4629

Adina Tahir 14L-4639

Sana Mansoor 14L-4631

Date: 17-10-17
Contents
Black Monday-An Overview ........................................................................................................................ 1
Market Condition before the Crash ........................................................................................................... 1
Causes of Black Monday .............................................................................................................................. 3
Forced Selling ........................................................................................................................................... 7
Effects of Black Monday 1987 ..................................................................................................................... 9
Learning Outcomes ..................................................................................................................................... 11
How the crises should be avoided ........................................................................................................... 11
Sticking to the strategy............................................................................................................................ 11
Buying on Fear........................................................................................................................................ 12
Turning the noise off ............................................................................................................................... 12
Do not believe the hype .......................................................................................................................... 12
Expectation beats reaction ...................................................................................................................... 12
Time heals all sores ................................................................................................................................. 12
Conclusion ................................................................................................................................................... 13
References ................................................................................................................................................... 14

List of Figures
Figure 1: S&P 500 Index Viewed in Short Term.......................................................................................... 5
Figure 2: S&P 500 Index viewed over the full year...................................................................................... 5
 Black Monday-An Overview
The recent global financial crisis occurred in the last quarter of 1987. That day goes by the name
of “Black Monday.” Black Monday is the term used to relate to history’s biggest percentage fall
in stock market. A train of events of market chaos made global stock exchanges crash within hours.
The event took place on 19th of October, 1987. Dow Jones Industrial Average which is also known
as the DJIA fell 22.61 %, falling 508 points to 1738.74. The Standard &Poor’s 500 Index dropped
20.4 %, dropping 57.64 points to 225.06. These falls were even worse the than the 1929’s crash
and no single day during 2008’s crisis came close to that particular day. For the compensation of
its loss, it took Dow Jones 2 whole years. October is mostly the month when falls and crashes have
taken place in financial markets. The crash of 1929 occurred in October, when 23% of fall occurred
in a period of two days. On the 27th of October, 1997 the DJIA fell 7.2%. The Black Monday
highlighted the idea of globalization, which was a relatively new concept for people. Black
Monday events projected how financial markets of the world had become related to each other.
Black Monday instigated certain significant reforms. One of these reforms was to bring a
temporary halt to trading in the time of speedy sell-off in the market.

Market Condition before the Crash

For about 5 years, the prices in the stock market had been rising, encouraging investors to invest
more. The drivers of this very bull market were low interest rates, aggressive acquisitions, buyouts
that were leveraged and mergers. A number of corporations were struggling to increase funds to
acquire other businesses. The philosophy that was being followed at that time was that by simply
acquiring other businesses, a company could grow to a substantial level. A way of raising huge
sums of capital was selling junk bonds to people. This is also known as a leveraged buyout. Junk
bonds possess huge default risk, and thus pay high amount of interest rate. The capital amount that
was collected by selling huge amounts of junk bonds led to acquisition of the company a particular
company wanted to acquire. The Initial Public Offerings were also gaining popularity in the
market. An Initial Public Offering are the stocks issued by a company in the market for the very
first time. The market flourished by 43 percent in 1987, and achieved about 2,746.65 on 25th
August, 1987. The trading level remained pretty much constant with slight downfall till the 2nd of
October. After that day, substantial fall occurred. During the 2 weeks before the Black Monday,
there was a fall of about 15%.

1
Earlier, tax-free loans were provided to aid business acquisitions. A bill was proposed on October
15 to eliminate the tax deduction for loans used to fund business buyouts. During 1980s a number
of big names including Michael Milken & Ivan Boesky were found involved in the illicit insider
trading on forth coming takeovers & mergers. For controlling and monitoring the market, this bill
was of importance. The introduction of the bill was made on the 13th of October. The bill was
approved on the 15th of October. In between three days, the prices of the stocks dropped greater
than 10 percent. History had never witnessed such a huge drop in stock prices in a 3-days period.
Furthermore, the stocks that fell the most were the companies that would have been hurt the most
by the legislation. The tax deduction was eliminated from the whole bill prior to it becoming a
proper law.

In the 80’s, microcomputers or personal computers were the fastest growing industry. People
began to embrace the very idea that computers would bring a revolution in all sectors, especially
the world of business. Before the 1987 crash, the dependence on computers for flow of cash
between markets and delivery of orders in the market had increased to a substantial level. The
processes that were associated with handling of customers’ orders were computerized by The New
York Stock Exchange. It was found that the computerization actually contributed to what happened
on 19th October. Sell-off was even made worse by Automated Stock Trading Programs. Sell-off is
basically the fast selling of financial securities. Greater the supply of securities greater the decline
in their value.

On the 16th of October, a major announcement was made by James Baker, the Treasury Secretary
at that time. According to him, the United States of America would deliberately lower the price of
its dollar. The rationale behind Baker’s decision was to lure foreign investors by lowering stock
prices. According to Baker, this step had to be taken in order to lower the rising trade deficit in the
U.S. There was an expectation of an even higher rise in trade deficit. (Browning, 2007)

The stock markets in the Asian region began crashing prior to the opening of markets in America
on the 19th for stocks trading. The difference between the numbers of sellers and buyers in the
market became huge. There were immensely greater numbers of sellers than there were buyers.
The stocks market of New Zealand experienced a fall of almost 60%. In United States of America,
the DJIA fell 22.61 %, falling 508 points to 1738. According to the chief executive of Intel Corp.
at that time, Andrew Grove, "There is so much psychological togetherness that seems to have
worked both on the up side and on the down side. It’s a little like a theater where someone yells
'Fire!'” (Colombo, 2012)

Figure 1: S&P 500 Index Viewed in Short Term

Figure 2: S&P 500 Index viewed over the full year

(Amadeo, 2017)
To be covered in the Project:
This project would provide an insight to:

 The market condition prior to the crash

 The causes that led to a crash so big in magnitude
 The after-effects of the crash on the global financial markets

Causes of Black Monday

According to an interview on CNBC (Mitchell, 2017); The government Brady Commission “this
is a team made in 1988 by United State President Ronald Reagan in order to explore the causes
behind crash of stock market 1987 and to give recommendations to prevent this situation from
happening again. This commission recommends that restrictions must be set on up to what extend
the security can rise or fall in price during time of volatility. Also the Federal Reserve has to take
a powerful regulatory position in securities.” (Farlex Financial Dictionary, 2012)

This commission said that the break down was mainly caused by “mutual funds meeting liberation
instructions” and “institutional investor using portfolio insurance”. Portfolio insurance was a
program to sell out equity futures since there was a fall in prices systematically.

Portfolio insurance was becoming moderately popular during that year along with the institutional
investors. 4½ years before 1987, the market had strongly come together and that year was pretty
good. The money managers as of mutual funds, pension funds and insurance funds seemed at
landscape. They started worrying about their profits that it would not last during the remaining
year. So, hedge became famous. In short, institutions who were buying the products were engaged
in a contract to sell short futures of S&P 500 (S&P 500 calculates the value the stock of major 500
companies mentioned on the New York Stock Exchange or Nasdaq Stock Market) by market
capitalization in the case of decline in stock market by convinced amount. This concept would
allow them to compensate the losses that a significant turndown would cause on portfolio.
Prior to 1987, if the investors started selling assertively in a falling stock market this is because
they did not have any other choice available. They were receiving fringe calls and they had to
vend. Through portfolio insurance, the investors didn’t have to sell in order to increase funds. They
were contractually bound to sell out in the falling market because of their portfolio insurance
contracts. This program be set with a formula, there are futures of certain amount that would be
sold short following the market had dropped by certain amount. Still if the market continuously
directed towards declining, they started short further futures as broken into further levels by S&P
index. The problem arise when investors of various other diverse areas had to sell on the same
moment with every obligation the situation became worst. Another significant attribute of this
market that took part in 1987 crash beside with the introduction of bills by Means Committee and
House ways was considered as a risk arbitrage and M&A (mergers and acquisitions) setting of the
time. The strategy of risk arbitrage is an attempt to simultaneously purchase a company’s stock
that is being obtained and short selling of the company that is acquired. The exploratory method
attempt to take benefits of the spread among time of announcing a deal until it closes.

In 1980’s most of the deals were aggressively take over, so it was quite risky. These deals were
typically invested by high yield debt. Thus, there was a high leverage amount involved. Moreover
numerous investors were heavily gambling on rumors throughout the streets regarding these deals.
Few of these rumors were about precise deals that involved the risk of getting called off because
of increased interest rate. In this theory, the acquirer would not be in the position to put the needed
bonds for sale or the interest rate would be high enough that doesn’t make any sense to create the
deal. After that a new issue was carried into the market i.e. Rostenkowski (U.S President) and his
committee. On 13th October, he began a takeover tax bill so that there were restrictions positioned
on takeover and on other company’s restructurings that is very important for M&A’s. We can say
that these bills would have revoke many tax reductions identified with M&A action. This and not
concerning the impact of higher rated to the economy as well as stock market was considered as
an actual reason that increasing interest rates were important during the crash of 1987. According
to the author, on 14th October he remembered a call from Harvard Management trader questioning
about what happened with the takeover stocks. The question was “Why were they all down so
much”? The appropriate response was this bill out of Rostenkowski's committee which led these
leveraged risk arbitrage dealers to hold back their certain positions. Prices of the stocks of these
deals were declined especially after rumors of M&A activities or other important deals that were
not occur. There investors were panic already on the impact of high rates on deals and then this
news directed them towards removal of their certain leveraged positions.
Till Thursday things did not settle down but Standard & Poor's 500 did not turn down significantly.
Then on Friday nothing had originated from Washington that demonstrated they would hold off
on the bills. A number of takeover stocks again declined sharply on Friday. Liquidity was
decreasing so the risk arbitrage companies were not able to meet their margin calls by trading the
takeover stocks. So that these companies had to sell what they possibly would sell. Then Monday
came, abroad markets were in a panic situation due to all that took place on Friday. When the
United state investors go to their jobs on Monday, there was a poor condition of global markets.
Liquidity continued to diminish and the group of people in a risk arbitrage freedom had to carry
on selling “what they could”. The problem occurs when “mutual funds redemption” strikes the
market it caused the similar type of forced selling. This is the source of force selling and had a
larger impact dollar amount terms. This didn’t end there. The players of the portfolio insurance
had not started yet. The stock market felt drastically as the forced selling caused from margins
calls of merger arbitrage players and from the mutual funds redemptions.

This forced selling led the holders of portfolio insurance to the trigger level. When the holders
magic level were busted they started they started selling their short futures in a significant way
which worsen the sell off i.e. selling of a securities rapidly at low price and the increasing supply
of a particular security reduces its value. (Investopedia Academy , 2017) When the market further
sold off investors were used to call their mutual funds and started trading more shares.

Therefore on 19th October 1987, the stock market crashed. It was considered as a perfect storm.
There were investors in leveraged risk arbitrage who were required to sell in order to meet margin
calls. Also, there were mutual funds that forced to sell in order to meet mutual fund redemptions.
After that there were portfolio insurance investors they were forced to sell contractually in order
to insure their portfolios.

The above mentioned investors were at risk due to rising interest rates, but the main reason was
bill by Rostenkowski's committee that became the means that flash the crash. In general, the crash
was set on fire by the miserable trial balloon i.e. an unsure measure that is taken in order to see the
effects of newly made policy but the basis of leverage had taken into place. Fortunately, 2/3 of the
forced selling was not because of margin calls and the percentage of funds involved in this forced
selling was larger than that. Thus, as the mutual fund sellers and the investors of portfolio insurance
were not calm down the leveraging it didn’t became an economic event similar to 1929 and 2008.

By this event one thing to make sure is that crashes are not at all caused by poor incomes or poor
economic growth. Those things become the reasons of recessions but not of crashes. The one thing
that caused a crash was “forced selling”.

Forced Selling
Forced selling is the spontaneous sale of securities or assets in order to liquidate in the occurrence
of a situation that is uncontrollable. This is usually carried out in response of any economic event,
changes in personal life, company’s policies or any legal order by the government. (Investopedia
Academy, 2017)

Effects of Black Monday 1987

The stock market crash of 1987 did not only have an effect on U.S. stock market but it also affected
the stock markets of the World severely. At the time of crash in stock market, the return through
World’s markets in high- incidence information was strongly correlated in detection of beyond
normal noise related to trade occurring domestically. Interdependency of foreign markets might
have changed perception of investors by increasing the concerns regarding news about financial
situation in foreign markets. Due to this, there was an increase in correlation between returns on
stocks and volatility in markets on the permanent basis.

Various studies exhibits the effect of stock market crash in October 1987

 Roll in 1988 examined the transmission of crash to major markets around the Globe.
 King Wadhwani in 1990 looked for the period of 8 months around the crash and termed it
as contagion which means the crash of one market leads to crash in other stock markets.
The increased correlation among World’s stock markets was also observed by them.
 Neumark Tinsley Tosini in 1988 examined that there was dual listing of stocks of U.S. in
London and Tokyo. There was an overnight change in price previously that predicted the
movements of prices in New-York. There was an increase in predictability that was seen
in the period of one month after the crash.
  The study of Von Furstenberg Jeon in 1989 and Rogers in 1990 shows that there was a
shift in relation of returns in stock markets of World followed by Black Monday.
 One study of Ito Roley in 1987 examined the impacts of actually announced news on the
volatility level of Yen/Dollar rate of exchange in numerous geographical market segments
in 24 hours. Announced surprises of Money supply of US have steady impact on volatility
of exchange rate
 Bailey in 1990 studied the impact of announcements related to money supply of U.S on
stock market indices of the Pacific Rim and found that these markets shows reactions in
prices similar to that in US market. In these capital markets, differences in sensitiveness of
the news were determined partially by the amount of restrictions in international capital
flows. (Hamao, Masulis, & Ng, 1991)

On 19th October 1987, there was a massive decrease in percentages in the history of Wall Street.
Normally, the disastrous news, the index fall up to just 5 percent but on the Black Monday, it fell
up to 22.6 percent. Standard and Poor 500 index also fell on that day. After this, no single day
witnessed such a large decline because the restrictions were imposed by the regulators on the stock
trading because it became clear that the financial sector was being hit strongly.

Before 1987, crashes were limited to either markets of stock, bond, commodity or gold. But Black
Monday hit every market simultaneously for example Chicago’s futures and options markets,
New-York’s trading of treasury and gold markets and also every country’s stock markets. The
panic spread throughout the World leading to the shuttering of Hong Kong Stock Market for 7
days and there was a recorded fall in financial capitals. The crash bypassed the old financial
regulations with such a speed that exposed the compartmentalized system of regulations that
cannot respond to a crisis coherently.

Due to the abrupt business volume on that day, the computerized system of Federal Reserve on
which the bank depended for the cash transfers, was not used for hours. This crash led the markets
to the new and different way of working because it was seen that in the future there was absence
of isolation in the markets of the World and that one market involved the big investors that rushed
in and out of different investments at a speed and a measure that is different from ever before.
At the time of panic, the regulators were compelled to coordinate their actions that were only
confined to some sections of the integrated market. So the practical and hard-headed leaders
emerged who stepped out of their old authorities and helped in regaining the confidence of
investors and in making the panic to calm down. The president of New York Federal Reserve bank
named E. Gerald Corrigan and Chairman of New York Stock Exchange named John J. Phelan Jr.
were those practical leaders in 1987 crises.

After the 1987 crash, Nicholas F. Brady who was the future secretary for treasury led the blue
ribbon commission attempted to convince Wall street to consider the stock, options and futures
markets as a the one market. Another commission known as Brady emphasized that there should
be empowerment of a sole regulator who can then examine this integrated market carefully and
can take actions in case of emergence of systematic risk. However, markets are still regulated in
the same way they used to be regulated before the crisis even after 3 decades.

As the economy of U.S. escaped the recession, they feel less worried about the Brady
Commission’s alerts. Another crisis in savings and loans industry caused Congress and regulators
to face problems that are politically weighted that diverted their attention to devise modern ways
to regulate the derivatives and stock markets. (Henriques, 2017)

Black Monday proved to be the most notorious day in history of finance as it also led to decline in
stock market of World. After the Black Monday, many mechanisms for protection have been
developed so that the panic selling including circuit breakers and curbs in trading can be prevented.
Algorithms of High Frequency trading that are driven by super-computers however move a number
of volumes in milliseconds only thus leading to increased volatility. (Investopedia)

Learning Outcomes

How the crises should be avoided

Crashes seem to be the end of the world but their duration is always temporary.

Sticking to the strategy

The markets that suffer steep declines always recover and come back to new highs in the period
following the crash. Investors should have set their aims for investing followed by properly-
devised longer-term strategy for investing that would help them not to panic. Not having a strategy
let investor’s emotions guide their decisions. Investors who have continued their investments in
S&P 500 index from 1987 have gained 10.13 percent annualized rate of return.

Buying on Fear
Market crisis is not permanent and it should be looked upon as an opportunity of purchasing
securities. These crises are unavoidable so you should also be prepared about which securities are
attractive to be bought at reduced prices and which are not.

Turning the noise off

Crises in markets show small ups and downs in performance of the portfolio that is well-structured.
Events in short-term market cannot be predicted and they can be forgotten quickly. Long term
investors should not adopt herd like behavior and focus on the aims set by them for long term.
(Investopedia)

Do not believe the hype

Before crash, the stock market of united state was viewed as a definite winner as it had raised 44
percent followed the incredible performing years. But right after the crash the equities of the United
State markets were criticized as a terrible investment that would not recovered. The important
thing to note is that the more the opposite viewpoints of investors are turned out to be true. The
crowd of investors is hardly right when all moved in a same direction because the prices in the
market shows each person’s collective optimism. It is noted that the prices of assets are expensive
when investors become too optimistic and cheaper when investors are pessimistic. (Duran, 2917)

Expectation beats reaction

Investors must ensure the riskiness of portfolio must not be greater than the person can handle. It
is essential for investor to in a condition to survive in any situation and be prepared mentally to
bear loses if any. The investors must calculate what amount they would loss if the portfolio
declined to 25% and be ready to adjust these risks and be prepared mentally. (Duran, 2917)

Time heals all sores

If you were purchasing a stock on Friday prior to large sell off you would purchase it at higher
price and faced a huge decline on the next day of your purchase. But at the 30th anniversary of that
event the price of that stock is even ten times higher. Time heals all the sores so the investor should
not panic in the crisis situation and not started selling during the decline of market. When you rely
on long term investment make sure you have many years of savings rather than suddenly change
your mind. Let the time to settle the things back rather than bear losses by keeping out money from
the market. (Duran, 2917)

Conclusion
Black Monday 1987 was the largest single day decline in the history of stock markets up till now.
The increased dependency on computers has led to what happened on that day. The crash was
followed by the diminishing liquidity and increased selling off of securities. Rumors spread and
investors were worried. The globalization of markets was not the matter of concern for investor
before. Regulators were required after the crash to view all the markets as single market and to
keep an eye on all the announcements but nothing has been implemented up till now. The crashes
could not be avoided but the investors could tackle the panic by focusing on their longer-term
investment strategy and do not worry about the rumors. Because time is the best healer and the
declining stock prices will rise again one day and even greater to the previous level.
References
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Browning, E. (2007, October 15). Exorcising Ghosts of Octobers Past. The Wall Street Journal.

Colombo, J. (2012, August 3). Black Monday – the Stock Market Crash of 1987. Retrieved from The
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Hamao, Y., Masulis, R. W., & Ng, V. (1991). The Effect of the 1987 Stock Crash on International Financial
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Henriques, D. B. (2017, 09 19). Those Who Don’t Learn From Financial Crises Are Doomed to Repeat
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https://www.theatlantic.com/business/archive/2017/09/financial-crisis-black-monday/539859/

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https://www.investopedia.com/terms/b/blackmonday.asp

Mitchell, G. (2017, 10 16). The real reason for the 1987 crash, as told by a Salomon Brothers veteran. (M.
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