The Black-Scholes equation’s assumption of known underlying prices failed on NASDAQ’s dealer structure.

Evidence

Black, Scholes, and other options theorists had implicitly (the matter was never expressly discussed) assumed that the price of the underlying stock was known. With NASDAQ, that pervasive assumption failed. So, in 1986, the CBOE launched its first “Autoquote” system. In the crowds within which NASDAQ options were traded, CBOE employees would feed in the prices of the most liquid options, those with strike price close to the current stock price. Autoquote software implementing the Black- Scholes equation would then generate the price of a “synthetic underlying,” in other words, calculate the stock price compatible with those option prices. From that it would generate and make public to traders the Black- Scholes prices of the full range of options being traded, including the less liquid ones for which preceding market prices might be a poor guide (Knorring interview). — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 130

Categorization

• DEFINE: Clarifies what a ‘synthetic underlying’ is — the stock price reverse-engineered from liquid option prices via the Black-Scholes equation.
• XREF: Connects to the performativity literature (Callon, MacKenzie) — theory constructing the market infrastructure that realizes it. — connects to: Black-Scholes assumes away the price gaps that would break its hedging strategy. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 805; Broker collateral rules made Black-Scholes’ discounting assumption inapplicable to warrant short sales. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 559; Black-Scholes legitimized options despite fitting prices only approximately — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 707
• CANDY: A nice concrete instance: the exchange reverse-engineers the underlying stock price from option quotes when no liquid stock price exists.

Related

• The CBOE automated away the missing stock price by calculating a synthetic underlying. (similarity 0.86)
• Black-Scholes legitimized options despite fitting prices only approximately (similarity 0.84)
• Black-Scholes assumes away the price gaps that would break its hedging strategy. (similarity 0.80)
• Broker collateral rules made Black-Scholes’ discounting assumption inapplicable to warrant short sales. (similarity 0.80)
• The market changed to fit Black-Scholes rather than the reverse (similarity 0.79)
• Black’s original derivation assumed CAPM pricing of both stock and warrant (similarity 0.79)
• Option price must equal the cost of a continuously adjusted replicating portfolio. (similarity 0.78)
• The Black-Scholes methodology reshaped economists’ and regulators’ thinking beyond derivatives. (similarity 0.78)
• Black-Scholes pricing rests on idealized no-friction market assumptions. (similarity 0.78)

Broader Connections

• Black-Scholes assumes away the price gaps that would break its hedging strategy. #expands (0.90) — Donald MacKenzie, An Engine, Not a Camera, 805
• Broker collateral rules made Black-Scholes’ discounting assumption inapplicable to warrant short sales. #qualifies (0.75) — Donald MacKenzie, An Engine, Not a Camera, 559
• Black-Scholes legitimized options despite fitting prices only approximately #qualifies (0.72) — Donald MacKenzie, An Engine, Not a Camera, 707