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The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

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Chapter 13: Alan Greenspan Stops a Random Plunge Down Wall Street

The crash of 1987 exposes big flaws in the rational finance view of risk. But a rescue by the Federal Reserve averts a full reexamination.

Hayne Leland could see, almost from the moment portfolio insurance popped into his head in the den of his Berkeley house, that there was a catch. The option-pricing formulas upon which he based the strategy depended on the portfolio insurer being a price taker. That is, prices were set by the “pervasive forces” of the market. The actions of an individual market participant were presumed to have no impact at all.

If Leland’s idea hit it big enough, he realized, the actions taken by portfolio insurers trying to cut their clients’ losses ...

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