Econometric model tests can be passed because traders’ arbitrage removes model deviations.

Evidence

A fundamental aspect of what Rubinstein did was, therefore, to check the empirical validity of a basic feature of the Black-Scholes-Merton 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, Rubinstein checked whether the graph of implied volatility against strike price was a flat line, as it should be on the model. There was thus a homology between the econometric testing of the Black-Scholes-Merton model and the trading-floor use of the model in “spreading.” When spreaders used the model (for example, by following the instructions that accompanied Black’s sheets) to look for discrepancies, it would be precisely deviations from that flat line that they would have identified and that their activities would have tended to “arbitrage away.” It seems, therefore, that the model may have been helped to pass its central econometric test “with remarkable fidelity” (Rubinstein 1994, p. 772) by the market activities of those who used it. — Donald MacKenzie, An Engine, Not a Camera, 737

Categorization

• DEFINE: Explains what the implied-volatility flat line test actually is and how ‘spreading’ maps onto it.
• DEEPTHINKING: The homology between statistical testing and arbitrage practice — the test itself becoming a self-fulfilling loop — is the heart of the performativity thesis, hard to compress.
• XREF: connects to: Traders arbitraging model discrepancies directly improved the model’s econometric test results — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 146; Traders used the model’s own arbitrage logic to profit in the market. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 731; Constrained arbitrage allows finance-theory models to diverge from actual prices. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1213 (+2 more)

Broader Connections

• Traders’ arbitrage activity made the pricing model appear empirically true #corroborates (0.95) — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 126
• Constrained arbitrage allows finance-theory models to diverge from actual prices. #contradicts (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1213
• Limited arbitrage capital can force abandonment of even certain-profit trades #complicates (0.75) — Donald MacKenzie, An Engine, Not a Camera, 1217