Journal de l'économie mondiale

Have We Learned from Previous Stock Meltdowns?

Abstract

Michel A and Shaked I

We have witnessed three major stock market meltdowns over the past three decades. This paper assesses the market shocks of 1987, 1997 and 2008. In particular, we review the history of modern finance and assess whether the role of quantitative finance has developed to reduce the likelihood of future meltdowns. We see that the role of models based on historical price movement often ignore the possibility of fat tails, that risk free arbitrage may exist in normal, but not tumultuous markets and that asset returns and correlations result in extreme values more frequently than predicted by the standard bell curve. Moreover, the desire for outsized returns has driven many money managers to leverage their returns beyond prudent levels, dramatically increasing portfolio risk. In addition, many in Wall Street sell and create new derivative products that are often sold without the necessary due diligence and properly conducted stress tests. The same quantitative courses are taught and similar derivative products are sold as during the three previous meltdowns. Unfortunately, the SEC and academia have taken little permanent action to reduce the odds of further stock meltdowns.