The purpose of this paper is to examine the role of derivative securities in over‐pricing and market corrections.
Daily market data from major indices are used to determine if the market was over‐priced in 1987. Then, the literature is examined to show differences in research findings for what caused the bubble and its correction.
Evidence is found that there was a market bubble in 1987. Examples are provided of how portfolio insurance can lead to the aggregation of traders' idiosyncratic errors and to an increase in the use of leverage, both of which can cause over‐pricing.
Although the analysis is limited to equity markets, the findings should stimulate further research on the relationship between derivatives and asset pricing. Theoretically, derivative prices should be a function of asset prices, but it could be argued that the relationship is symbiotic.
The findings may impact policy makers in establishing regulations regarding the use of derivatives. Moreover, asset managers may be able to better detect conditions of over‐pricing.
The paper demonstrates the important role of derivative securities in market prices.
