Large banks realize the model’s zero-transaction-cost assumption through portfolio internalization

Evidence

As noted above, the theory of derivatives also enables the risks involved in derivatives portfolios to be decomposed mathematically, and in the case of large investment banks, many of these risks turn out to be mutually offsetting. In consequence, the residual risk to be hedged is often quite small in relation to the overall derivatives portfolio of a major financial intermediary such as a big investment bank (Merton 1992, pp. 450-457). Such banks can thus “operate on such a scale that they can provide liquidity as if they had no transaction costs” (Taleb 1998, p. 36). … As a result, the Black-Scholes-Merton model’s assumption of zero transaction costs is now close to true for the hedging of derivatives by major investment banks, in part because the use of that model and its descendants by those banks allows them to manage their portfolios in a way that minimizes transaction costs. — Donald MacKenzie, An Engine, Not a Camera, 1160

Categorization

• DEFINE: Explains how a model’s simplifying assumption becomes approximately true in practice through disciplined portfolio management — the performativity mechanism at work.
• XREF: Direct payoff of the chapter 1 performativity framing and the ‘as-if’ hypothesis debate with Friedman. — connects to: Credit-risk regulation imports market-finance models developed for traded securities. — Ève Chiapello, Financialisation of Valuation, 60