The writer is professor of finance and risk management at Henley Business School

War and geopolitical tensions have always shaped financial market stability and volatility. But how close to home does a conflict have to be for panic to set in and for structural fragilities to surface?

The current war in Iran has already had significant repercussions for mortgage rates, interest rates and inflation because of the impact of global oil prices. Yet questions remain about the likely impact on asset pricing in markets closely exposed to, but not directly involved in, the conflict.

To explore the connection between geopolitical events and financial performance, it is worth revisiting Monday October 19 1987, when the stock market in the largest global economy, the US, plunged almost 22 per cent in a single trading day.

Financial markets have never been the same since Black Monday, and traders today still factor in the possibility of such a “black swan” event when managing extreme downside risk.

Academic books on financial investments and financial risk management were rewritten and new models invented to cope with the extreme probability that it could happen again. Regulators have found a new milestone to match, and stress testing now requires that equity modelling be capable of generating such extreme events.

While updated measures and innovation of models became the norm in the 1990s and 2000s, there has not been another Black Monday event since. The stock markets recovered relatively quickly and risk management adapted by introducing the “value-at-risk” measure as a yardstick for gauging extreme risk. 

Malign alignments

However, despite all the innovation in response to the old ways of doing finance, the sector forgot to answer the most important question: “What caused Black Monday, 1987?”

Some commentators at the time associated the actual crash with programme trading, which in turn was dealing with large hedging programmes that could be much more easily executed because of the introduction of computers on a wider scale in investment banking.

This seemed to suggest it was an internal issue within financial markets, and an anomaly that aligned in a malign way on the fateful day of October 19.

But programme trading did not cause the crash. Instead, its roots lay outside the financial markets altogether. In the week before Black Monday, the US military engaged Iran in attacks on ships, military assets and oil infrastructure. It was not a large-scale military operation, but sufficient enough to unsettle Asian stock markets, where fears quickly spread that a much broader conflict, potentially even a third world war, could be imminent. 

Asian markets reacted first, followed by European markets, both rushing to reduce US stock exposure. The wave of selling on Friday October 16 1987 was difficult to detect from London, as the London Stock Exchange was closed due to a severe storm, limiting ability to track market information. By the weekend, US traders had learned of the sharp declines in Asia, and when markets opened on Monday, the same pattern engulfed the New York Stock Exchange.

The US-Iran confrontation served as the trigger of the crash. It was the detonator, while programme trading created the exposure and amplified existing vulnerabilities. Together, these forces delivered the most severe one-day market event in financial history.

Clear triggers

The current conflict in Iran inevitably raises the question: could such a market crash happen again? The simple answer is yes, it’s possible. We have already seen sharp declines in South Korean equities, renewed concerns about a bubble in AI-related stocks, and additional instability caused by volatile cryptocurrency markets. Meanwhile, gold prices continue to climb alongside oil.

The current conflict in Iran inevitably raises the question: could such a market crash happen again? The simple answer is yes, it’s possible

Whether we experience another crash on the scale of Black Monday 1987 remains to be seen. Major crises tend to require two key ingredients: significant risk exposure and a clear trigger event. If either is missing, a full-scale crisis resulting in a crash, is less likely.

However, what is almost certain is that equity markets will undergo some degree of correction as investors respond to the ongoing conflict and uncertainty surrounding it. The bang this time could be even bigger because, in addition to direct investment in US stocks, there are huge indirect investments through indexed funds.

As the saying goes: “You don’t have to run faster than the tiger. You only have to run faster than the slowest person in the group.” And when everyone starts to believe that, diversification will not help to manage risk because highly correlated herding behaviour takes over, with all portfolio managers doing the same and running for safety. Then we will hear the big bang and the books will be rewritten once again. 

Radu Tunaru, professor of finance and risk management, Henley Business School