Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange

Donald MacKenzie, Yuval Millo
American Journal of Sociology

Add Remove

references Introduction: The Embeddedness of Economic Markets in Economics on 6/5/2019, 1:34:40 PM

tag-as Black–Scholes model on 6/5/2019, 1:35:26 PM

excerpt The study of the CBOE thus allows the question of performativity to be given a precise formulation. Why was option pricing theory so successful empirically? Was it because of the discovery of preexisting price regularities? Or did the theory succeed empirically because participants used it to set option prices? Did it make itself true? 109 on 6/5/2019, 1:37:45 PM

cites The Social Structure of a National Securities Market on 6/5/2019, 1:45:14 PM

excerpt Baker (1984a, 1984b) examined the pattern of trading and the behavior of prices in two CBOE trading crowds, one large and one small. After taking account of the volatility of the underlying stocks, Baker found that, contrary to the predictions of economic theory, option prices were more volatile in the larger crowd, an effect he explained by the tendency of this crowd to fragment into subnetworks when trading was intense. As one trader told him, “In the really large crowds that are really active, it’s possible to get trading in very different prices. [Why?] It’s noisy; you can’t hear” (quoted by Baker 1984b, p. 786). The small crowd, in contrast, tended to remain stable in membership, and always small enough for easy communication. Prices in it tended to remain stable, even as trading became more intense. A trader active during the late 1970s, when Baker was studying the CBOE, explained to us that the cause was essentially collective action in the smaller “crowds” (see also Baker 1984a): The larger crowds were . . . really competitive and . . . sometimes egos would get in the way and . . . some guy would get a trade and the next guy would say “Well, I would have paid an eighth better for twice the amount,” and there’d be screaming and shouting. But in some of the slower pits . . . there wasn’t as much competition, then there would [be] more of a sharing basis, which was always a problem to some of the firms because they viewed them . . . somewhat as cliques and nobody would ever break rank in terms of pricing. If an order came in, and the market would be [bid] one-eighth, [ask] one-half, or something . . . nobody would ever sell it at three-eighths, nobody would ever break rank. on 6/5/2019, 1:47:09 PM

excerpt In contrast, Black, Scholes, and Merton’s arguments were at their core simple and elegant. If the price of a stock followed the standard model of a lognormal random walk in continuous time, and other simplifying assumptions held (see below), it was possible to hedge any option transaction perfectly. In other words, it was possible to construct a continuously adjusted portfolio of the underlying stock and government bonds or cash that would “replicate” the option: that would have the same return as it under all possible states of the world. Black, Scholes, and Merton then reasoned that the price of the option must equal the cost of the replicating portfolio: if their prices diverged, arbitrageurs would buy the cheaper and short sell the dearer, and this would drive their prices together. 120 on 6/5/2019, 1:50:36 PM

excerpt Black-Scholes was really what enabled the exchange to thrive. . . . It gave a lot of legitimacy to the whole notions of hedging and efficient pricing, whereas we were faced, in the late 60s–early 70s with the issue of gambling. That issue fell away, and I think Black-Scholes made it fall away. It wasn’t speculation or gambling, it was efficient pricing. I think the SEC very quickly thought of options as a useful mechanism in the securities markets and it’s probably—that’s my judgment—the effects of Black-Scholes. 121 on 6/5/2019, 1:52:04 PM

excerpt This empirical success was not due to the model describing a preexisting reality: as noted, the initial fit between reality and model was fairly poor. Instead, two interrelated processes took place. First, the markets gradually altered so that many of the model’s assumptions, wildly unrealistic when published in 1973, became more accurate. 122 on 6/5/2019, 1:55:12 PM

excerpt To the increasing veracity of the Black-Scholes-Merton model’s assumptions was added the second process: the model’s growing use as a guide to trading. If that use had been as rapid and widespread as later accounts (e.g., Passell 1997) have suggested, it would raise the possibility that the model’s success was a simple self-fulfilling prophecy. 123 on 6/5/2019, 1:58:09 PM

excerpt Pricing models soon began to seem an “inherent part” (SEC 1979, p. 137) of spreading, and the strategy’s popularity helps explain why, by 1976–78, the fit between prices on the CBOE and the Black-Scholes-Merton model was so good on the crucial econometric test by Rubinstein, described above. A key aspect of what Rubinstein did was to check the empirical validity of a basic feature of the model: “that all options on the same underlying asset with the same time-to-expiration but with different striking prices should have the same implied volatility” (Rubinstein 1994, p. 772), in other words that the graph of implied volatility against strike price should be a flat line. When spreaders used Black-Scholes to identify discrepancies, it would be precisely deviations from that flat line that their activities tended to arbitrage away. The model was, therefore, helped to pass its central econometric test by the market activities of those who used it. 126 on 6/5/2019, 2:00:45 PM

excerpt Human beings remain in ultimate command: by pressing on the section of screen marked “lean,” traders can manually override model values, and, furthermore, the ebb and flow of orders in actively traded option classes do move prices. Nevertheless, such human interaction is now merely one aspect of a larger technosystem. 128 on 6/5/2019, 2:02:22 PM

excerpt Black, Scholes, and Merton’s model did not describe an already existing world: when first formulated, its assumptions were quite unrealistic, and empirical prices differed systematically from the model. Gradually, though, the financial markets changed in a way that fitted the model. In part, this was the result of technological improvements to price dissemination and transaction processing. In part, it was the general liberalizing effect of free market economics. In part, however, it was the effect of option pricing theory itself. Pricing models came to shape the very way participants thought and talked about options, in particular via the key, entirely model-dependent, notion of “implied volatility.” The use of the Black-Scholes-Merton model in arbitrage— particularly in “spreading”—had the effect of reducing discrepancies between empirical prices and the model, especially in the econometrically crucial matter of the flat-line relationship between implied volatility and strike price. 137 on 6/5/2019, 2:10:41 PM

references Laws of the Markets on 6/5/2019, 2:12:07 PM

excerpt Yes, homo economicus does exist, but is not an a-historical reality; he does not describe the hidden nature of the human being. He is the result of a process of configuration. . . . Of course it mobilizes material and metrological investments, property rights and money, but we should not forget the essential contribution of economics in the performing of the economy. 22-23 on 6/5/2019, 2:12:54 PM

references Threshold model on 6/5/2019, 2:15:03 PM

cites Turning Callon the right way up on 6/5/2019, 2:18:59 PM