Option pricing theory did not describe markets but remade them in its own image

Evidence

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. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 182

This analysis of the history of the Chicago Board Options Exchange explores the performativity of economics, a theme in economic sociology recently developed by Callon. Economics was crucial to the creation of financial derivatives exchanges: it helped remedy the drastic loss of legitimacy suffered by derivatives in the first half of the 20th century. Option pricing theory—a “crown jewel” of neoclassical economics—succeeded empirically not because it discovered preexisting price patterns but because markets changed in ways that made its assumptions more accurate and because the theory was used in arbitrage. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 9

Categorization

• XREF: The core performativity argument that MacKenzie later expanded into ‘An Engine, Not a Camera.’ The ‘implied volatility flattening’ is the crucial empirical mechanism. — connects to: Economic theory succeeded in derivatives markets partly by making markets conform to it — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 9; Economic theory, not trader demand, forged the proposal for the stock-options exchange — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 63; Spanning multiple options markets forced firms to adopt pricing models — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 121 (+17 more)
• DEEPTHINKING: The claim that a theoretical model, through the practical use of its own vocabulary (implied volatility) and arbitrage activity, actively closes the gap between reality and the model is the central, paradigm-shifting insight of financial performativity.
• DEFINE: Implied volatility is model-dependent — a genuinely counterintuitive concept where the model’s own output becomes a market convention that then disciplines reality.
• SEED: An article thesis: what other ‘facts’ do our measurement tools actually construct rather than detect?
• corroborated: 2 independent passages support this claim — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 182; Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 9

Related

• Economic theory succeeded in derivatives markets partly by making markets conform to it (similarity 0.92)
• Option theory infrastructure allows derivatives markets to exist at current scale (similarity 0.89)
• Organized options trading alone could explain post-model price convergence to Black-Scholes (similarity 0.88)
• Market conditions moved toward the model’s assumptions partly because of the model itself (similarity 0.88)
• The market changed to fit Black-Scholes rather than the reverse (similarity 0.88)
• Option prices are routinely quoted in implied volatility, a purely theoretical construct (similarity 0.87)
• The Black-Scholes model gained market traction slowly, not through instant self-fulfilling prophecy. (similarity 0.87)
• Black-Scholes-Merton theory shaped exchange fortunes before markets changed to match it. (similarity 0.87)
• Implied volatility concepts and calculation devices are constitutive of economic action (similarity 0.87)
• Market prices converged toward Black-Scholes values within a few years of the CBOE’s founding (similarity 0.87)
• The Black-Scholes methodology reshaped economists’ and regulators’ thinking beyond derivatives. (similarity 0.87)
• Traders using the pricing model actively made market prices conform to the model (similarity 0.86)
• Option pricing theory serves as the test case for performativity. (similarity 0.86)
• Black-Scholes fit option prices well for eleven years, then stopped after 1987 (similarity 0.86)
• Option pricing converged on economic models through traders copying other users. (similarity 0.86)

Broader Connections

• Option theory infrastructure allows derivatives markets to exist at current scale #expands (0.90) — Donald MacKenzie, An Engine, Not a Camera, 1138