Mackenzie Bricolage e Performatividade

An Equation and Its Worlds: Bricolage, Exemplars, Disunity and Performativity in Financial
Economics
Author(s): Donald MacKenzie
Source: Social Studies of Science, Vol. 33, No. 6 (Dec., 2003), pp. 831-868
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Sss
ABSTRACT Thispaperdescribesand analysesthe history of the fundamental

equationof modernfinancialeconomics:the Black-Scholes (or Black-Scholes-Merton)
optionpricingequation.Inthathistory, severalthemesof potentially general
importance are revealed.First,
the keymathematical workwas not rule-following but
bricolage,creativetinkering.Second,itwas, however,bricolageguided bythe goal
of findinga solutionto the problemof optionpricinganalogousto existing
exemplary solutions,notablythe CapitalAssetPricingModel,whichhad successfully
been appliedto stockprices.Third,the centralstrandsof workon optionpricing,
althoughall recognizably 'orthodox'economics,were not unitary. Therewas
significant
theoreticaldisagreement amongstthe pioneersof optionpricingtheory;
thisdisagreement, turnsout to be a strength
paradoxically, of the theory.Fourth,
optionpricingtheoryhas been performative. Ratherthansimplydescribing a pre-
italteredthe world,in generalin a waythatmade
existingempiricalstateof affairs,
itselfmoretrue.
Keywords Black-Scholes,
bricolage,optionpricing, socialstudiesof
performativity,
finance
An Equation and its Worlds:

Bricolage,Exemplars,Disunityand
in FinancialEconomics
Performativity
Donald MacKenzie
Economics and economiesare becominga majorfocusforsocial studiesof

science. Historiansof economics such as Philip Mirowskiand the small
number of sociologists of economics such as Yuval Yonay have been
applyingideas fromscience studieswithincreasingfrequencyin the last
decade or so.' Establishedscience-studiesscholarssuch as Knorr Cetina
and newcomersto thefieldsuch as Izquierdo,Lepinay,Millo and Muniesa
have begun detailed, oftenethnographic,work on economic processes,
with a particular focus on financial markets.2Actor-networktheorist
Michel Callon has conjoinedthe two concernsby arguingthatan intrinsic
linkexistsbetweenstudiesofeconomicsand ofeconomies.The economyis
not an independentobject thateconomicsobserves,arguesCallon (1998).
Rather,the economy is performedby economic practices.Accountancy
and marketingare among the more obvious such practices,but, claims
Callon, economics in the academic sense plays a vitalrole in constituting
and shapingmoderneconomies.
Social StudiesofScience33/6(December 2003) 831-868

?) SSS and SAGE Publications(London, Thousand Oaks CA, New Delhi)
[0306-3127(2003 12)33:6;83 1-868;039200]
www.sagepublications.com

832 Social Studies of Science 33/6
This paper contributesto the emergentscience-studiesliteratureon

economics and economies by way of a historicalcase study of optiont
pricingtheory(termsmarkedt are definedin the glossaryinTable 1). The
theoryis a 'crownjewel' of moderneconomics:'when judged by its ability
to explainthe empiricaldata, optionpricingtheoryis the most successful
theorynot onlyin finance,but in all ofeconomics' (Ross, 1987: 332). Over
thelastthreedecades, optiontheoryhas become a vitallyimportantpartof
financialpractice.As recentlyas 1970, the marketin derivativest such as
options was tiny; indeed, many modern derivativeswere illegal. By
December 2002, derivativescontractstotalingUS$165.6 trillionwere
outstandingworldwide,a sum equivalentto around US$27,000 forevery
human being on earth.3Because of its centrality to thishuge market,the
equationthatis myfocushere,the Black-Scholesoptionpricingequation,
may be 'the most widelyused formula,with embedded probabilities,in
human history'(Rubinstein,1994: 772).
The developmentof option pricingtheoryis part of a largertrans-
formationof academic finance.Untilthe 1960s, the studyof financewas a
marginal,low statusactivity:largelydescriptivein nature,taughtin busi-
ness schools not in economics departments,and with only weak in-
tellectuallinkagesto economic theory.Since the 1960s, financehas be-
come analytical, theoretical and highly quantitative.Although most
academicfinancetheorists'postsare stillin businessschools,muchofwhat
theyteach is now unequivocallypartof economics.Five financetheorists-
includingtwo of the centralfiguresdiscussedhere,RobertC. Merton and
MyronScholes - have won Nobel prizesin economics.
This intellectualtransformation was interwoven withthe rapid expan-
sion of businessschools in the US. In the mid-1950s,US businessschools
were producing around 3000 MBAs annually.By the late 1990s, that
figurehad risen to over 100,000 (Skapiner,2002). As business schools
grew,theyalso became more professionaland 'academic', especiallyafter
the influentialFord Foundationreport,HigherEducationforBusiness(Gor-
don and Howell, 1959). At the same time,the importanceof the finance
sectorin theUS economygrewdramatically, and increasingproportionsof
financialassets wereheld not directlyby individualsbut by organizations
such as mutual fundsand pension funds.These organizationsformeda
readyjob marketforthe growingcohortsof studentstrainedin finance.
The transformation oftheacademic studyoffinanceis the subjectof a
finehistoryby Bernstein(1992), and the interactionsbetweenthistrans-
formation,the evolutionof US business schools, and changingcapital
marketshave been analysed ably by Whitley(1986a, 1986b). However,
whatthe existingliterature has not done fullyis to 'open the black box' of
mathematicalfinancetheory. That - at leastforthetheoryofoptionpricing
- is thispaper's goal.4
Limitationof space means that the focus of this paper is on the
mathematicsof option pricingtheoryand on its intellectualcontext.The
interactionbetweentheoryand practice- the processesof the adoptionby
practitionersofoptionpricingtheory,and theconsequencesofitsadoption

MacKenzie: An Equation and its Worlds 833
- is the subject of a 'sister'paper (MacKenzie and Millo, forthcoming),

althoughthe issue of performativity means thatthe subject-matter of that
paper willbe revisitedbrieflybelow.
In thisarticle,fourthemeswill emerge.I would not describethemas
'findings',because of the limitationson whatcan be inferredfroma single
historicalcase-study,but theymay be of general significance.The first
themeis bricolage.Creativescientific practiceis typicallynot thefollowing
of set rules of method:it is 'particularcourses of action withmaterialsat
TABLE I
Terminology
Arbitrage; arbitrageur Tradingthatseeks to profitfromprice discrepancies;a trader

who seeks to do so.
Call See option.
Derivative An asset,such as a future or option, the value of whichde-
pends on the price of another,'underlying',asset.
Discount To calculatethe amountby whichfuturepaymentsmustbe
reducedto givetheirpresentvalue.
Expiration See option.
Future A contracttradedas an organizedexchangein whichone party
undertakesto buy,and the otherto sell, a set quantityof an
asset at a set price on a givenfuturedate.
Implied volatility The volatilityof a stockor index consistentwiththe price of
options on the stockor index.
Log-normal A variableis log-normally
distributedifitsnaturallogarithm
followsa normaldistribution.
Market maker In the optionsmarket,a marketparticipantwho tradeson his/
her own account,is obligedcontinuouslyto quote pricesat
whichhe/shewill buy and sell options,and is not permittedto
executecustomerorders.
Option A contractthatgivesthe right,but not obligation,to buy ('call')
or sell ('put') an asset at a givenprice (the 'strikeprice') on, or
up to, a givenfuturedate (the 'expiration').
Put See option.
Riskless rate The rateof interestpaid by a lenderwho creditorsare certain
will not default.
Short selling The sale of a securityone does not own, e.g. by borrowingit,
sellingit, and laterrepurchasingand returning it.
Strike price See option.
Swap A contractto exchangetwo income streams,e.g. fixed-rate
and
intereston the same notionalprincipalsum.
floating-rate
Volatility The extentof the fluctuationsof the price of an asset, conven-
tionallymeasuredby the annualizedstandarddeviationof con-
tinuously-compounded returnson the asset.
Warrant A call option issued by a corporationon its own stock.Its
exercisetypicallyleads to the creationof new stocksratherthan
the transferof ownershipof existingstock.

hand' (Lynch, 1985: 5). Whilethishas been documentedin overwhelming

detail by ethnographicstudiesof laboratoryscience, this case-studysug-
gests it may also be the case in a deductive, mathematicalscience.
Economists- at least the particulareconomistsfocusedon here- are also
bricoleurs.5
They are not, however,random bricoleurs,and the role of existing
exemplarysolutionsis the second issue to emerge.Ultimately,of course,
this is a Kuhnian theme. As is well known,at least two quite distinct
meaningsof the keyterm'paradigm'can be foundin Kuhn's work.One -
by farthe dominantone in how Kuhn's workwas takenup by others- is
the 'entireconstellationof beliefs,values,techniques,and so on sharedby
the membersof a given [scientific]community'(Kuhn, 1970: 175). The
second - rightly describedby Kuhn as 'philosophically... deeper' - is the
exemplar,the problem-solution thatis accepted as successfuland thatis
creatively drawn upon to solve furtherproblems (Kuhn, 1970: 175; see
also Barnes, 1982).
The role of the exemplarwill become apparenthere in the contrast
between the work of Black and Scholes and that of mathematicianand
arbitrageurtEdward 0. Thorp. Amongst those who worked on option
pricingprior to Black and Scholes, Thorp's work is closest to theirs.
However,whileThorp was seekingmarketinefficiencies to exploit,Black
and Scholes were seeking a solution to the problem of option pricing
analogous to an existingexemplarysolution,the Capital Asset Pricing
Model. This was not justa generalinspiration:in his detailedmathematical
work,Black drewdirectlyon a previousmathematicalanalysison whichhe
had worked with the Capital Asset Pricing Model's co-developer,Jack
Treynor.
As PeterGalison and othershave pointedout, the keyshortcomingin
the view of the 'paradigm' as 'constellationof beliefs,values, techniques,
and so on' is thatit overstatesthe unityand coherenceof scientificfields
(Galison, 1997; Galison and Stump, 1996). Nowhere is this more true
than when outsidersdiscuss 'orthodox' neoclassical economics, and the
nature of economic orthodoxyis the thirdtheme exploredhere. Black,
Scholes, Merton,severalof theirpredecessors,and most of those who in
the 1970s subsequentlyworked on option pricingwere all (with some
provisosin the case of Black, to be discussedbelow) recognizably'ortho-
dox' economists.As others studyingdifferent areas of economics have
found, however,orthodoxyseems not to be a single unitarydoctrine,
substantiveor methodological(see Mirowskiand Hands, 1998;Yonay and
Breslau, 2001). For example, Robert C. Merton, the economistwhose
name is most closelyyokedto those of Black and Scholes, did not accept
the originalversionof the Capital AssetPricingModel, the apparentpivot
of theirderivation,and Merton reached the Black-Scholes equation by
drawingon different intellectualresources.Black, in turn,never found
Merton's derivationentirelycompelling,and continuedto champion the
derivationbased on theCapital AssetPricingModel. So no entirely unitary
'constellationof beliefs,values, techniques,and so on' can be found.

Economic 'orthodoxy'is a reality- attendconferencesof economistswho

feelexcluded by it, and one is leftin no doubt on that- but it is a reality
that should perhaps be construedas a clusterof familyresemblances,a
clusterthatarisesfromimaginativebricolagedrawingon an onlypartially
overlappingset of existingexemplarysolutions.'Orthodox' economics is
an 'epistemicculture'(Knorr Cetina, 1999), not a catechism.
A major aspect of Galison's critiqueof the Kuhnian paradigm (con-
ceived as all-embracing'constellation')is his argumentthat diversityis a
sourceofrobustness,not a weakness.Though Galison's topicis physics,his
conclusion also appears to hold true of economics. Philip Mirowskiand
Wade Hands, describingthe emergenceofmoderneconomicorthodoxyin
the postwarUS, put the point as follows:
Ratherthansayingit [neoclassicism]simplychased out the competition-

whichit did, ifby 'competition'one means the institutionalists,
Marxists,
and Austrians- and replaced diversity witha singlemonolithichomoge-
neous neoclassical strain,we say it transformeditselfinto a more robust
ensemble.Neoclassical demand theorygained hegemonyby going from
patches of monoculturein the interwarperiod to an interlockingcom-
petitiveecosystemafterWorldWar II. Ratherthan presentingitselfas a
single,brittle,theoreticalstrand,neoclassicismoffereda more flexible,
and thusresilientskein. (Mirowskiand Hands, 1998: 289; see also Sent,
forthcoming)
As we shall see, that general characterizationappears to hold for the

particularcase of optionpricingtheory.
The final theme explored here, and in the sisterpaper referredto
above (MacKenzie and Millo, forthcoming), is performativity.As we shall
see, thereis at least qualifiedsupporthereforCallon's conjecture,albeitin
a case thatis favourableto the conjecture,since optionpricingtheorywas
chosen for examinationin part because it seemed a plausible case of
performativity. Optionpricingtheoryseems to have been performative in a
strongsense: it did not simplydescribe a pre-existing world,but helped
createa worldof whichthe theorywas a truerreflection.
It is of course not surprisingthata social science like financetheory
has thepotentialto alteritsobjectsof study:themoredifficult issue,which
fortunately does not need to be breachedhere,is to specifyaccuratelythe
non-trivialways in whichnaturalsciences are performative (see Hacking,
1992a, and froma different viewpoint,Bloor, 2003). That a social science
likepsychology, forexample,has a 'necessarilyreflexive
character'and that
psychologistsinfluenceas well as describe'the psychologicallives of their
host societies'has been arguedby Richards(1997: xii), and Ian Hacking's
work(such as Hacking, 1992b and 1995a) also demonstratesthepoint.As
I have argued elsewhere(MacKenzie, 2001), financeis a domain of what
Barnes (1983) calls 'social-kind' terms or what Hacking (1995b) calls
'human kinds', with theirtwo-way'looping effects'between knowledge
and its objects.
It is clearlypossible in principle,in otherwords,forfinancetheoryto
be performative ratherthan simplydescriptive.However, that does not

remove the need for empirical examination.That the theory can be

performative does not implythatit has been performative. Indeed, as we
shall see, the performativity of classic option pricingtheoryis incomplete
and historically specific- it did not make itselfwhollyor permanently true
- and exploringthe limitsand the contingencyof its performativity is of
some interest.
'Too Much on Finance!'

Optionsare old instruments, but untilthe 1970s age had notbroughtthem
respectability.Putst and callst on the stock of the Dutch East India
Company were being bought and sold in Amsterdamwhen de la Vega
discussed its stock marketin 1688 (de la Vega, 1957), and subsequently
optionswerewidelytradedin Paris,London, NewYorkand otherfinancial
centres.They frequentlycame under suspicion,however,as vehiclesfor
speculation.Because the cost of an option was typicallymuch less than
thatof the underlyingstock,a speculatorwho correctlyanticipatedprice
rises could profitconsiderablyby buyingcalls, or benefitfromfalls by
buyingputs,and such speculationwas oftenregardedas manipulativeand/
or destabilizing.Buying options was oftenseen simplyas gambling,as
bettingon stockprice movements.In Britain,optionswere banned from
1734 and again from1834, and in France from1806, althoughthesebans
were widelyflouted(Michie, 1999: 22, 49; Preda, 2001: 214). Several
American states,beginningwith Illinois in 1874, also outlawed options
(Kruizenga, 1956). Althoughthe main targetin the USA was optionson
agriculturalcommodities,options on securitieswere often banned as
well.
Options' dubious reputationdid not preventseriousinterestin them.
In 1877, forexample,the London brokerCharles Castelli,who had been
'repeatedlycalled upon to explainthevariousprocesses'involvedin buying
and sellingoptions,publisheda bookletexplainingthem,directedappar-
entlyat his fellowmarketprofessionalsratherthan popular investors.He
concentratedprimarily on theprofitsthatcould be made by thepurchaser,
and discussedonlyin passinghow optionswerepriced,notingthatprices
tended to rise in periods of what we would now call high volatility.t
His
booklet ended - in a nice correctiveforthose who believe the late 20th
century'sfinancialglobalizationto be a novelty- withan example of how
options had been used in bond arbitragetbetween the London Stock
Exchange and the ConstantinopleBourse to capturethe high contango6
rateprevailingin Constantinoplein 1874 (Castelli, 1877: 2, 7-8, 74-77).
Castelli's 'how to' guide employedonly simple arithmetic.Far more
sophisticatedmathematically was the thesissubmittedto the Sorbonnein
March 1900 byLouis Bachelier,a studentoftheleadingFrenchmathema-
tician and mathematicalphysicist,Henri Poincare. Bachelier sought 'to
establishthelaw ofprobabilityofpricechangesconsistentwiththemarket'
in Frenchbonds. He assumedthatthepriceofa bond, x, followedwhatwe
would now call a stochasticprocess in continuous time: in any time

interval,howevershort,the value of x changedprobabilistically.

Bachelier
constructedan integralequation thata continuous-timestochasticprocess
had to satisfy.
Denotingbyp, t dx theprobabilitythatthepriceof thebond
at timet would be betweenx and x + dx,Bacheliershowedthattheintegral
equation was satisfiedby:
H
p = H exp - (7TH2x2/t)
where H was a constant. (For the reader's convenience,notationused

throughoutthisarticleis gatheredtogetherinTable 2.) For a givenvalue of
t, the expressionreduces to the normal or Gaussian distribution,the
familiar'bell-shaped' curve of statisticaltheory.AlthoughBachelier had
not demonstratedthatthe expressionwas the onlysolutionof the integral
equation (and we now know it is not), he claimed that '[e]videntlythe
probabilityis governedby theGaussian law,alreadyfamousin the calculus
ofprobabilities'.He wenton to applythisstochasticprocessmodel- which
we would now call a 'Brownianmotion'because thesame processwas later
used by physicistsas a model of the path followedby a minuteparticle
subjectto randomcollisions- to variousproblemsin the determination of
the striketprice of options, the probabilityof their exercise and the
probabilityoftheirprofitability,
showinga reasonablefitbetweenpredicted
and observedvalues.7
When Bachelier'sworkwas 'rediscovered'by Anglo-Saxonauthorsin
the 1950s, it was regardedas a stunninganticipationboth of the modern
theoryof continuous-timestochasticprocesses and of late 20th-century
financetheory.For example,the translatorof his thesis,optiontheoristA.
JamesBoness, noted thatBachelier'smodel anticipatedEinstein'sstochas-
tic analysisof Brownianmotion (Bachelier, 1964: 77). Bachelier's con-
temporaries,however,wereless impressed.While modernaccounts of the
neglect of his work are overstated(Jovanovic,2003), the modesty of
Bachelier's career in mathematics- he was 57 beforehe achieved a full
TABLE2
Main Notation
(3 the covarianceof the price of an asset withthe generallevel of the market,dividedby

the varianceof the market
c striketprice of option
In naturallogarithm
N the (cumulative)normalor Gaussian distribution function
r risklesstrate of interest
a the volatilitytof the stockprice
t time
w warrantor optionprice
x stockprice
x* stockprice at expirationtof option
For itemsmarkedt see the glossaryin Table 1.

at Besancon ratherthanin Paris - seems due in part to his

professorship,
peers' doubts about his rigourand theirlack of interestin his subject
matter,the financialmarkets.'Too much on finance!' was the private
commenton Bachelier'sthesisby the leadingFrenchprobabilitytheorist,
Paul Levy (quoted in Courtaultet al., 2000: 346).
Option and Warrant Pricing in the 1950s and 1960s

The continuous-time randomwalk, or Brownianmotion,model of stock
marketprices became prominentin economics only fromthe late 1950s
onwards,and did so, furthermore, withan importanttechnicalmodifica-
tion, introducedto financeby Paul Samuelson, MIT's renownedmathe-
matical economist,and independentlyby statisticalastronomerM.F.M.
Osborne (1959). On Bachelier'smodel,therewas a non-zeroprobabilityof
prices becoming negative.When Samuelson, for example, learned of
Bachelier'smodel, 'I knewimmediatelythatcouldn't be rightforfinance
because it didn't respectlimitedliability'[Samuelson interview]:8 a stock
pricecould notbecome negative.So Samuelson and Osborne assumednot
Bachelier's 'arithmetic'Brownian motion, but a 'geometric' Brownian
motion,or log-normaltrandom walk, in whichprices could not become
negative.
In the late 1950s' and 1960s' US the random-walkmodel became a
key aspect of what became known as the 'efficientmarkethypothesis'
(Fama, 1970). Though it initiallystruckmanynon-academicpractitioners
as bizarreto posit thatstockprice movementswere random,the growing
number of financialeconomists argued that all today's informationis
alreadyincorporatedin today'sprices: ifit is knowablethatthe price of a
stock will rise tomorrow,it would alreadyhave risen today. Stock price
changesare influencedonlyby newinformation, which,by virtueof being
new, is unpredictableor 'random'.9 Like Bachelier, a number of these
financialeconomistssaw the possibilityof drawingon the random walk
model to studyoption pricing.Typically,theystudied not the prices of
optionsin generalbut thoseofwarrants.tOptionshad nearlybeen banned
in the US afterthe Great Crash of 1929 (Filer, 1959), and were traded
only in a small, illiquid, ad hoc marketbased in New York. Researchers
could in generalobtain onlybrokers'price quotationsfromthatmarket,
not the actual prices at which options were bought and sold, and the
absence of robustprice data made options unattractiveas an object of
study.Warrants,on the otherhand, weretradedin more liquid, organized
markets,particularly theAmericanExchange,and theirmarketpriceswere
available.
To Case Sprenkle,a graduatestudentin economicsatYale University
in the late 1950s, warrantprices were interestingbecause of what they
mightrevealabout investors'attitudesto and expectationsabout risklevels
(Sprenkle,1961). Let x* be thepriceof a stockon theexpirationt date of a
warrant.A warrantis a formof call option: it givesthe rightto purchase
the underlyingstock at strikeprice, c. At expiration,the warrantwill

MacKenzie:An Equation and its Worlds 839
be worthlessifx* is below c, since exercisingthe warrantwould

therefore
be more expensivethan simplybuyingthe stock on the market.If x* is
higherthan c, the warrantwill be worththe difference.So its value will
be:
0 ifx*<c
x* - c ifx*-c
Of course, the stockprice x* is not knownin advance, so to calculatethe

expectedvalue of the warrantat expirationSprenklehad to 'weight'these
final values by f(x*), the probabilitydistributionof x*. He used the
standardintegralformulaforthe expectedvalue of a continuousrandom
variable, obtainingthe followingexpressionfor the warrant'sexpected
value at expiration:
J
c
(x*- c) f(x*)dx*
To evaluatethisintegral,Sprenkleassumed thatf(x*) was log-normal(by

the late 1950s, that assumptionwas 'in the air', he recalls [Sprenkle
interview]),and that the value of x* expected by an investorwas the
currentstock price x multipliedby a constant,k. The above integral
expressionforthe warrant'sexpectedvalue thenbecame:
ln(kx/c)+ s212 ln(kx/c)- s2/2

kxN[ L L ] (1)
s s
whereln is the abbreviationfornaturallogarithm,s2 is the varianceof the

distributionof lnx*, and N is the (cumulative) Gaussian or normal
distribution function,thevalues ofwhichcould be foundin tablesused by
any statisticsundergraduate.'0
Sprenklethen argued that the expectedvalue of a warrantwould be
thepricean investorwould be preparedto pay forit onlyiftheinvestorwas
indifferent to risk or 'risk neutral'. (To get a sense of what this means,
imagine being offereda fair bet with a 50 percent chance of winning
$1,000 and a 50 percentchance of losing $1,000, and thus an expected
value of zero. If you would requireto be paid to takeon such a bet you are
'risk averse'; if you would pay to take it on you are 'risk seeking';if you
would takeit on withoutinducement,but withoutbeingpreparedto pay to
do so, you are 'riskneutral'.)Warrantsare riskierthantheunderlying stock
because of theirleverage- 'a givenpercentagechange in the price of the
stockwill resultin a largerpercentagechangein the price of the option' -
so an investor'sattitudeto risk could be conceptualized,Sprenklesug-
gested,as the price Pe he or she was preparedto pay forleverage.A risk-
seekinginvestorwould pay a positiveprice, and a risk-averseinvestora

negativeone: thatis, a leveredassetwould have to offeran expectedrateof

return sufficientlyhigher than an unlevered one before a risk-averse
investorwould buy it. V the value of a warrantto an investorwas then
given,Sprenkleshowed,by:
ln(kxlc)+ s'12 ln(kxlc)- s'12

V= kxN[ () ] - (I - PI)cN nk /] (2)
s s
(The righthand side ofthisequationreducesto expression1 in thecase of

a riskneutralinvestorforwhom Pe= 0.) The values of k, s, and Pe were
posited by Sprenkleas specificto each investor,representing his or her
subjectiveexpectationsand attitudeto risk.Values of V would thus vary
between investors,and 'Actual prices of the warrantthen reflectthe
consensus of marginalinvestors'opinions - the marginalinvestors'ex-
pectationsand preferencesare the same as the market'sexpectationsand
preferences'(Sprenkle,1961: 199-201).
Sprenkleexaminedwarrantand stockpricesforthe 'classic boom and
bustperiod' of 1923-32 and fortherelativestabilityof 1953-59, hopingto
estimatefromthose prices 'the market'sexpectationsand preferences',in
other words the values of k, s, and Pe implied by warrantprices. His
econometricwork, however,hit considerable difficulties: 'it was found
impossibleto obtain these estimates'.Only by arbitrarily assumingk = 1
and testingout a range of arbitraryvalues of Pe could Sprenklemake
partial progress. His theoretically-derived formula for the value of a
warrantdepended on parameterswhose empiricalvalues were extremely
problematicto determine(Sprenkle,1961: 204, 212-13).
The same difficulty hit the most sophisticatedtheoreticalanalysisof
warrantsfromthis period, by Paul Samuelson in collaborationwiththe
MIT mathematicianHenry P. McKean, Jr.McKean was a world-class
specialist in stochastic calculus, the theory of stochasticprocesses in
continuoustime,whichin the yearsafterBachelier'sworkhad burgeoned
intoa keydomainofmodernprobability theory.Even withMcKean's help,
however,Samuelson'smodel (whichspace constraints preventme describ-
ing in detail) also depended,like Sprenkle's,on parametersthatseemed to
have no straightforward empiricalreferents: the expectedrateof return
rOc,
on the underlyingstock, and r,, the expected returnon the warrant
(McKean, 1965; Samuelson, 1965). A similarproblemwas encounteredin
the somewhatsimplerwork of Universityof Chicago PhD student,A.
JamesBoness. He made the simplifying assumptionthatoptiontradersare
risk-neutral,but his formulaalso involvedrOc,whichhe could estimateonly
indirectlyby findingthe value that minimizedthe differencebetween
predictedand observedoptionprices (Boness, 1964).
'The Greatest Gambling Game on Earth'

Theoreticalanalysisof warrantand option prices thus seemed alwaysto
lead to formulaeinvolvingparametersthatwere difficultor impossibleto

estimate.An alternativeapproach was to eschew a priorimodels and to

studythe relationshipbetweenwarrantand stockprices empirically. The
mostinfluential workofthiskindwas conductedby Sheen Kassouf.Aftera
mathematicsdegreefromColumbia University, Kassouf set up a success-
fultechnicalillustration
firm.He was fascinatedby the stockmarketand a
keen,ifnot alwayssuccessful,investor.In 1961, he wantedto investin the
defencecompanyTextron,but could not decide betweenbuyingits stock
or itswarrants[Kassoufinterview].He startedto examinethe relationship
betweenstockand warrantprices,findingempiricallythata simplehyper-
bolic formula
W= v C2+x2 - c
seemed roughlyto fitobservedcurvilinearrelationshipsbetweenwarrant

price,stockprice and strikeprice (Kassouf, 1962: 26).
In 1962, Kassouf returnedto Columbia to studywarrantpricingfora
PhD in economics.His earliersimplecurvefitting was replacedby econo-
metrictechniques,especiallyregressionanalysis,and he posited a more
complexrelationshipdetermining warrantprices:
w/c = [(X/C)Z + 1] 1Z - 1 (3)
wherez was an empirically-determined functionofthestockprice,exercise

price, stock price 'trend',"1time to expiration,stock dividend,and the
extentof the dilutionof existingshares thatwould occur if all warrants
were exercised(Kassouf, 1965).
Kassouf's interestin warrantswas not simplyacademic: he wanted'to
make money'tradingthem[Kassoufinterview].He had rediscovered,even
beforestartinghis PhD, an old formof securitiesarbitraget (see Weinstein,
1931: 84, 142-45). Warrantsand the correspondingstocktendedto move
together:ifthe stockprice rose, thenso did the warrantprice; ifthe stock
fell,so did thewarrant.So one could be used to offsettheriskoftheother.
If, forexample,warrantsseemed overpricedrelativeto the corresponding
stock,one could shortselltthem,hedgingthe riskby buyingsome of the
stock.Tradingof thissort,conductedby Kassouf in parallelwithhis PhD
research,enabled him 'to more than double $100,000 in just fouryears'
(Thorp and Kassouf, 1967: 32).
In 1965, freshfromhis PhD, Kassouf was appointedto the facultyof
thenewlyestablishedIrvinecampus oftheUniversity of California.There,
he was introducedto mathematician Edward 0. Thorp. Alongsideresearch
in functionalanalysisand probabilitytheory,Thorp had a long-standing
interestin casino games.While at MIT in 1959-61 he had collaborated
withthe celebratedinformation theoristClaude Shannon on a tiny,weara-
ble, analog computersystemto predictwherethe ball would be deposited
on a roulettewheel [Thorp interview].Thorp went on to devise the first
effective methodsforbeatingthe casino at blackjack,by keepingtrackof
cardsthathad alreadybeen dealt and thusidentifying situationsfavourable
to the player(Thorp, 1961; Tudball, 2002).

Thorp and Shannon's use of theirwearable roulettecomputerwas

limitedby frequently brokenwires,but card-countingwas highlyprofit-
able. In the MIT spring recess in 1961, Thorp travelledto Nevada
equipped witha hundredUS$100 bills providedby two millionaireswith
an interestin gambling.After30 hours of blackjack,Thorp's US$10,000
had become US$21,000. He went on to devise,with computerscientist
William E. Walden of the nuclear weapons laboratoryat Los Alamos, a
method for identifying favourableside bets in the version of baccarat
played in Nevada. Thorp found, however,that beating the casino had
disadvantagesas a way of makingmoney.At a timewhenUS casinos were
controlledlargelyby organizedcriminals,therewere physicalrisks:while
Thorp was playingbaccaratin 1964, he was renderedalmostunconscious
by knock-outdropsadded to his coffee.The need to travelto places where
gamblingwas legalwas a further disadvantageto an academicwitha family
[Thorp interview].
Increasingly,Thorp's attentionswitchedto the financialmarkets.'The
greatestgamblinggame on earth is the one played daily throughthe
brokeragehouses acrossthe country',Thorp told thereadersof thehugely
successfulbook describinghis card-counting methods(Thorp, 1966: 182).
But could the biggestof casinos succumb to Thorp's mathematicalskills?
Predictingstockprices seemed too daunting:'thereis an extremelylarge
numberof variables,manyof whichI can't get any fixon'. However,he
realizedthat'I can eliminatemostofthevariablesifI thinkabout warrants
versuscommonstock' [Thorp interview]. Thorp began to sketchgraphsof
the observedrelationshipsbetweenstockand warrantprices,and meeting
Kassouf provided him with a formula (equation 3 above) for these
curves.
Their book, Beat theMarket(Thorp and Kassouf, 1967), explained
graphicallythe relationshipbetweenthe price of a warrant,w, and of the
underlyingcommon stock,x (see Figure 1). No warrantshould evercost
more than the underlyingstock,since it is simplyan option to buy the
latter,and thisconstraintyieldeda 'maximumvalue line'. At expiration,as
Sprenklehad noted,a warrantwould be worthlessifthestockprice,x, was
less thanthe strikeprice,c; otherwiseit would be worththe difference (x -
c). If, at any time,w < x - c, an instantarbitrageprofitcould be made by
buyingthe warrantand exercisingit (at a cost of w + c) and sellingthe
stockthus acquired forx. So the warrant'svalue at expirationwas also a
minimumvalue forit at any time.As expirationapproached,the 'normal
price curves' expressingthe value of a warrantdropped closerto its value
at expiration.
These 'normalprice curves'could thenbe used to identify overpriced
and underpricedwarrants.'2The formercould be sold short,and thelatter
bought,withthe resultantriskshedged by takinga positionin the stock
(buying stock if warrantshad been sold short; selling stock short if
warrantshad been bought). The appropriatesize of hedge, Thorp and
Kassouf explained(1967: 82), was determinedby 'the slope of thenormal
price curve at our startingposition'. If that slope were, say, 1:3, as it

FIGURE1
| v j~~~~Moth
before
A
Price of common,S
'Normalpricecurves'fora warrant.FromEdward0. Thorpand SheenT. Kassouf,Beat
the Market:A ScientificStockMarketSystem(New York:RandomHouse, 1967),31.
o Edward0. Thorpand SheenT. Kassouf.Used by permissionof RandomHouse,Inc.
S is Thorpand Kassouf'snotationforthe priceof the commonstock.
roughlyis at point (A,B) in Figure 1, the appropriatehedge ratiowas to

buy one unit of stockforeverythreewarrantssold short.Anymovements
along the normal price curve caused by small stock price fluctuations
would then have littleeffecton the value of the overallposition,because
the loss or gain on the warrantswould be balanced by a nearlyequivalent
gain or loss on the stock. Larger stockprice movementscould of course
lead to a shiftto a regionof the curvein whichthe slope differed
from1:3,
and in theirinvestmentpracticeboth Thorp and Kassouf adjusted their
hedges when thathappened (Thorp, 2002; Kassouf interview).
Initially,Thorp relied upon Kassouf's empiricalformulaforwarrant
prices (equation 3 above): as he says,'it produced ... curvesqualitatively
like the actual warrantcurves'.Yet he was not entirelysatisfiedwith it:
'quantitatively,I thinkwe both knewthattherewas somethingmore that
had to happen' [Thorp interview].He began his investigationof that
'something' in the same way as Sprenkle - applying the log-normal
distributionto work out the expected value of a warrantat expiration-
reachinga formulaequivalentto Sprenkle's(equation 1 above).
Like Sprenkle's,Thorp's formula(Thorp, 1969: 281) forthe expected
value of a warrantinvolvedthe expectedincreasein the stockprice,which
therewas no straightforward wayto estimate.He decided to approximateit
by assumingthatthe expectedvalue ofthe stockrose at the risklesstrateof
interest:he had no betterestimate,and he 'didn't thinkthat enormous
errorswould necessarilybe introduced' by the approximation.Thorp
foundthatthe resultantformulawas plausible- 'I couldn't findanything
wrong with its qualitativebehavior and with the actual forecastit was

making'- and in 1967 he startedto use it to identifygrosslyoverpriced

optionsto sell [Thorp interview].It was formallyequivalentto the Black-
Scholes formulafor a call option (equation 5 below), except for one
feature:unlikeBlack and Scholes,Thorp did not discounttthe expected
value of the option at expirationback to the present. In the warrant
marketshe was used to, the proceeds of the shortsale of a warrantwere
retainedin theirentiretyby thebroker,and werenot availableimmediately
to the seller as Black and Scholes assumed.'3It was a relativelyminor
difference:whenThorp read Black and Scholes, he was able quicklyto see
why the two formulaedifferedand to add to his formulathe necessary
discountfactorto make themidentical(Thorp, 2002). In thebackground,
however,lay more profounddifferences of approach.
Black and Scholes

In 1965, FischerBlack,witha HarvardPhD (Black, 1964) in whatwas in
effectartificialintelligence,joined the operationsresearchgroup of the
consultancyfirmArthurD. Little,Inc. There, Black met JackTreynor,a
financialspecialistat Little [Treynorinterview].Treynorhad developed,
thoughhad not published,whatlaterbecame knownas the Capital Asset
Pricing Model (also developed, independently,by academics William
Sharpe, John Lintner, and Jan Mossin).14It was Black's (and also
Scholes's) use of thismodel thatdecisivelydifferentiated theirworkfrom
the earlierresearchon optionpricing.
The Capital Asset PricingModel provideda systematicaccount ofthe
'risk premium':the additionalreturnthat investorsdemand forholding
riskyassets.That premium,Treynorpointedout, could not depend simply
on the 'sheer magnitudeof the risk',because some riskswere 'insurable':
theycould be minimizedby diversification, by spreadingone's investments
overa broad rangeof companies (Treynor,1962: 13-14; 1999: 20). What
could not be diversifiedaway,however,was the risk of general market
fluctuations.By reasoningof this kind,Treynorshowed - and the other
developersof the model also demonstrated- that a capital asset's risk
premiumshould be proportionalto its [ (its covariancewiththe general
levelofthemarket,dividedby thevarianceof themarket).An assetwhose
f was zero, in otherwords an asset the price of whichwas uncorrelated
withtheoveralllevelofthemarket,had no riskpremium(anyspecificrisks
involvedin holdingit could be diversified away),and investorsin it should
earn onlyr,therisklessrateofinterest. As theasset's 3 increased,so should
its riskpremium.
The Capital Asset PricingModel was an elegantpiece of theoretical
reasoning.Its co-developerTreynor became Black's mentorin whatwas for
Black thenew fieldoffinance,so it is not surprisingthatwhenBlack began
his own workin financeit was by tryingto applythe model to a rangeof
assets otherthan stock (whichhad been its main initialfieldof applica-
tion). Also importantas a resourceforBlack's researchwas a specificpiece
of jointworkwithTreynoron how companies should value cash flowsin

makingtheirinvestmentdecisions.This was the problemthat had most

directlyinspiredTreynor's development of the Capital Asset Pricing
Model, and the aspect of it on whichBlack and Treynorcollaboratedhad
involvedTreynorwritingan expressionforthechangein thevalue ofa cash
flowin a short,finitetimeintervalAt; expandingthe expressionusingthe
standardcalculus technique ofTaylorexpansion;takingexpectedvalues;
droppingthe termsof orderAt2and higher;dividingby At; and lettingAt
tend to zero so that the finitedifferenceequation became a differential
equation.Treynor'soriginalversionof the latterwas in errorbecause he
had leftout a second derivativethat did not vanish,but Black and he
workedout how to correctthe differential equation by adding the corre-
spondingterm.5
Amongstthe assets to which Black tried to apply the Capital Asset
PricingModel werewarrants.His startingpointwas directlymodelled on
his joint workwithTreynor,withw, the value of the warrant,takingthe
place of cash flow,and x, the stockprice,replacingthe stochastically
time-
dependent 'informationvariables' of the earlier problem. If Aw is the
change in the value of the warrantin timeinterval(t, t + At),
Aw= w(x + Ax, t + At) - w(x,t)
where Ax is the change in stock price over the interval.Black then

expanded thisexpressionin a Taylorseriesand took expectedvalues:
aw aw 1 a22 w 1 a2w
E(Aw) E(Ax) + At + - E(Ax2) + AtE(Ax) +- 2 At2
a3x a3t 2 aX2 a3xait 2 at'
whereE designates'expectedvalue' and higherordertermsare dropped.

Black thenassumed thatthe Capital Asset PricingModel applied both to
the stock and warrant,so that E(Ax) and E(Aw) would depend on,
respectively,the [ of the stockand the [ of the warrant.He also assumed
that the stock price followeda log-normalrandom walk and thatit was
permissible'to eliminatetermsthatare second orderin At'.These assump-
tions, a little manipulation,and lettingAt tend to zero, yielded the
differentialequation:
aw aw 1 3a2w
-= rw--rX-a --r X2a (4)
where r is the risklessrate of interestand o- the volatilityt

of the stock
price.16
'I spentmany,manydays tryingto findthe solutionto thatequation',
Black later recalled: 'I ... had never spent much time on differential
equations,so I didn't knowthe standardmethodsused to solve problems
like that'. He was 'fascinated'thatin the differential
equation apparently
key featuresof the problem (notablythe stock's 1Band thus its expected
return,a pervasivefeaturein earliertheoreticalworkon optionpricing)no
longerappeared. 'But I was stillunable to come up withthe formula.So I
put the problemaside and workedon otherthings'(Black, 1989: 5-6).

In the autumn of 1968, however,Black (stillworkingforArthurD.

Little in Cambridge,MA) met Myron Scholes, a young researcherwho
had just joined the financegroupin MIT's Sloan School of Management.
The pair teamed up withfinancescholar Michael Jensento conduct an
empiricaltestof the Capital Asset PricingModel, whichwas stilllargelya
theoreticalpostulate. Scholes also became interestedin warrantpricing,
not, it seems, throughBlack's influencebut throughsupervisingan MIT
Master's dissertationon the topic (Scholes, 1998). Scholes' PhD thesis
(Scholes, 1970) involvedthe analysisof securitiesas potentialsubstitutes
for each other,with the potentialfor arbitrageensuringthat securities
whose risks are alike will offersimilarexpected returns.Scholes' PhD
adviser,Merton H. Miller,had introducedthisformof theoreticalargu-
ment- 'arbitrageproof'- in whatby 1970 was alreadyseen as classicwork
withFranco Modigliani (Modiglianiand Miller, 1958). Scholes startedto
investigatewhethersimilarreasoningcould be applied to warrantpricing,
and began to considerthehedgedportfolioformedbybuyingwarrantsand
shortsellingthe underlyingstock(Scholes, 1998: 480).
The hedged portfoliohad been the centralidea of Thorp and Kas-
souf's Beat theMarket(1967), thoughScholes had not yetread the book
[Scholes interview].Scholes' goal, in any case, was different.Thorp and
Kassouf's hedgedportfoliowas designedto earnhigh returns withlow risk
in real markets.Scholes' was a desired theoreticalartifact.He wanted a
portfoliowitha [ ofzero: thatis, withno correlationwiththe overalllevel
of the market.If such a portfoliocould be created, the Capital Asset
PricingModel impliedthatit would earn, not high returns,but onlythe
riskless rate of interest,r. It would thus not be an unduly enticing
investment, but knowingthe rate of returnon the hedged portfoliomight
solve the problemof warrantpricing.
What Scholes could not workout, however,was how to constructa
zero-r portfolio.He could see thatthe quantityof sharesthathad to be
sold shortmustchangewithtimeand withchangesin the stockprice,but
he could not see how to determinethatquantity.'[A]fterworkingon this
concept,offand on, I stillcouldn'tfigureout analytically how manyshares
of stockto sell shortto createa zero-betaportfolio'(Scholes, 1998: 480).
Like Black, Scholes was stymied.Then, in 'the summeror earlyfall of
and Black describedthe different
1969', Scholes told Black of his efforts,
approach he had taken, in particular showing Scholes the Taylor series
expansion of the warrant price (Scholes, 1998: 480). The two men then
foundhow to constructa zero-[ portfolio.Ifthestockpricechangedbythe
small amountAx,the optionpricewould alterby aAx. So thenecessary
3w ~ 3ax
hedge was to shortsell a quantityax of stockforeverywarrantheld.This
a3x
was the same conclusionThorp and Kassouf had arrivedat: aw is their

ax
hedgingratio,the slope of the curveof w plottedagainstx as in Figure 1.

Whilethe resultwas in thatsense equivalent,it was embeddedin quite

a differentchain ofreasoning.Althoughtheprecisewayin whichBlack and
Scholes arguedthe pointevolvedas theywrotesuccessiveversionsof their
paper,'7 the crux of their mathematicalanalysis was that the hedged
portfoliomust earn the risklessrate of interest.The hedged portfoliowas
not entirelyfree from risk, they argued in August 1970, because the
hedging would not be exact if the stock price altered significantly and
because the value of an option alteredas expirationbecame closer.The
change in value of the hedged portfolioresultingfromstockprice move-
mentswould,however,depend onlyon themagnitudeofthosemovements
not on theirsign.It was, therefore, thekindofriskthatcould be diversified
away. So, according to the Capital Asset Pricing Model, the hedged
portfoliocould earn onlythe risklessrate of interest(Black and Scholes,
1970a: 6). In otherwords,the expectedreturnon the hedged portfolioin
the shorttimeinterval(t, t + At) is justitspriceat timet multipliedby rAt.
Simple manipulationof theTaylorexpansionof w(x + Ax, t + At) led to a
finitedifferenceequation that could be transformedinto a differential
equation by lettingAt tend to zero, and to equation 4 above: the Black-
Scholes optionpricingequation,as it was soon to be called.
As noted above,Black had been unable to solve equation4, but he and
Scholes now returnedto the problem.It was, however,stillnot obvious
how to proceed. Like Black, Scholes was 'amazed thatthe expectedrateof
returnon the underlyingstock did not appear in [equation 4]' (Scholes,
1998: 481). This promptedBlack and Scholes to experiment, as Thorp had
done, withsettingthe expectedreturnon the stockas the risklessrate,r.
They substitutedr fork in Sprenkle'sformulaforthe expectedvalue of a
warrantat expiration(equation 1 above). To get the warrantprice, they
thenhad to discounttthatterminalvalue back to the present.How could
theydo that?'Rathersuddenly,it came to us', Black laterrecalled.'If the
stockhad an expectedreturnequal to the [riskless]interestrate,so would
the option. Afterall, if all the stock's risk could be diversifiedaway, so
could all the option'srisk.If thebeta ofthe stockwerezero,thebeta ofthe
optionwould have to be zero too. ... [T]he discountratethatwould take
us fromtheoption'sexpectedfuturevalue to itspresentvalue would always
be the [riskless]interestrate' (Black, 1989: 6). These modificationsto
Sprenkle'sformulaled to the followingformulaforthe value of a warrant
or call option:
ln(x/c) + (r + 2o2)(t*- t)
w=xN[-
0-1 t* - t
+ (r-2-
ln(x/c -t t)
-c[exp{r(t- t*)}]N[In(xlc) + (r- (5
0-vt* -t
wherec is the strikeprice,o-the volatilityof the stock,t* the expirationof

the option,and N the Gaussian distribution function.Instead offacingthe
difficult
taskof directlysolvingequation 4, all Black and Scholes had now

to do was show by differentiating

equation 5 thatit (the Black-Scholescall
optionor warrantformula)was a solutionof equation 4.
Merton
Black's and Scholes' tinkeringwith Sprenkle's expected value formula
(equation 1 above) was in one sense no different fromBoness' orThorp's.
However,Boness' justification forhis choice ofexpectedrateofreturnwas
empirical- he chose 'the rateof appreciationmost consistentwithmarket
pricesofputs and calls' (Boness, 1964: 170) - and Thorp freelyadmitshe
'guessed' that the rightthingto do was to set the stock's rate of return
equal to the risklessrate: it was 'guessworknot proof' [Thorp interview].
Black and Scholes, on the otherhand, could prove mathematically that
theircall option formula(equation 5) was a solutionto theirdifferential
equation (equation 4), and the latterhad a clear theoreticaljustification.
It was a justification
apparentlyintimately bound up withthe Capital
Asset PricingModel. Not onlywas the model drawnon explicitlyin both
the equation's derivations,but it also made Black's and Scholes' entire
mathematicalapproach seem permissible.Like all othersworkingon the
problem in the 1950s and 1960s (with the exception of Samuelson,
McKean, and Merton), Black and Scholes used ordinarycalculus-Taylor
seriesexpansion,and so on - but in a contextin whichx, the stockprice,
was known to vary stochastically.Neither Black nor Scholes knew the
mathematicaltheoryneeded to do calculus rigorouslyin a stochastic
environment, but the Capital Asset PricingModel providedan economic
forwhatmightotherwisehave seemed dangerouslyunrigorous
justification
mathematics.'We did not knowwhetherour formulation was exact', says
Scholes, 'but intuitively we thoughtinvestorscould diversifyaway any
residualriskthatwas left'(Scholes, 1998: 483).
As noted above, Black had been a close colleague of the Capital Asset
PricingModel's co-developer,Treynor,whileScholes had done his gradu-
ate work at the Universityof Chicago, one of the two leading sites of
financialeconomics,wherethe model was seen as an exemplarycontribu-
tionto thefield.However,at the othermain site,MIT, the originalversion
of the Capital Asset PricingModel was regardedmuch less positively. The
model rested upon the 'mean-variance'view of portfolioselection:that
investorscould be modelled as guided only by theirexpectationsof the
returnson investmentsand their risks as measured by the expected
standarddeviationor varianceof returns.Unless returnsfolloweda joint
normal distribution(which was regardedas ruled out, because it would
imply,as noted above, a non-zeroprobabilityof negativeprices), mean-
varianceanalysisseemed to restupon a specificformof 'utilityfunction'
(the functionthatcharacterizesthe relationshipbetweenthe returnon an
investor'sportfolio,y, and his or her preferences).Mean-varianceanalysis
seemed to implythat investors'utilityfunctionswere quadratic: that is,
theycontainedonlytermsin y and y2.

For MIT's Paul Samuelson, the assumptionof quadratic utilitywas

over-specific- one of his earliestcontributions to economics (Samuelson,
1938) had been his 'revealedpreference'theory,designedto eliminatethe
non-empiricalaspects of utilityanalysis- and a 'bad ... representation of
human behaviour' [Samuelson interview].8Seen fromChicago, Samuel-
son's objections were 'quibbles' [Fama interview]when set against the
virtuesof the Capital Asset PricingModel: 'he's got to rememberwhat
Milton Friedmansaid - "Never mind about assumptions.What countsis,
how good are the predictions?"' [Millerinterview;see Friedman, 1953].
Nevertheless,theywere objectionsthat weighedheavilywith Robert C.
Merton. Son of the social theoristand sociologist of science Robert
K. Merton, he switchedin autumn 1967 fromgraduateworkin applied
mathematicsat the CaliforniaInstituteofTechnologyto studyeconomics
at MIT. He had been an amateur investorsince aged 10 or 11, had
graduatedfromstocksto optionsand warrants,and came to realize'thatI
had a muchbetterintuitionand "feel"intoeconomicmattersthanphysical
ones'. In spring1968, Samuelson appointedthe mathematically-talented
youngMerton as his researchassistant,even allocatinghim a desk inside
his MIT office(Merton interview;Merton, 1998: 15-16).
It was not simplya matterof Merton findingthe assumptionsunder-
pinningthe standardCapital AssetPricingModel 'objectionable'(Merton,
1970: 2). At the centreof Merton's workwas the effortto replace simple
'one-period' models of that kind with more sophisticated'continuous-
time' models. In the latter,not only did the returnson assets varyin a
continuousstochasticfashion,but individualstook decisions about port-
folio selection (and also consumption)continuously,not just at discrete
points in time. In any time interval,howevershort, individualscould
change the compositionof theirinvestmentportfolios.Compared with
'discrete-time'models, 'the continuous-timemodels are mathematically
morecomplex',saysMerton.He quicklybecame convinced,however,that
'the derivedresultsofthe continuous-time models wereoftenmoreprecise
and easier to interpretthan their discrete-timecounterparts'(Merton,
1998: 18-19). His 'intertemporal'capital asset pricingmodel (Merton,
1973), forexample,did not necessitatethe 'quadratic utility'assumption
of the original.
With continuous-timestochasticprocesses at the centreof his work,
Merton feltthe need not just to make ad hoc adjustmentsto standard
calculus but to learn stochasticcalculus. It was not yetpart of economists'
mathematicalrepertoire(it was above all Merton who introducedit), but
by the late 1960s a number of textbooktreatmentsby mathematicians
(such as Cox and Miller, 1965 and Kushner, 1967) had been published,
and Merton used these to teach himselfthe subject [Merton interview].
He rejected as unsuitable the 'symmetrized'formulationof stochastic
integration by R.L. Stratonovich(1966): it was easierto use forthosewith
experienceonlyof ordinarycalculus,but whenapplied to pricesit in effect
allowedinvestorsan illegitimate peek intothefuture.Mertonchose instead
the original 1940s' definitionof the stochasticintegralby the Japanese

mathematician,Kiyosi It6, and Uto'sassociated apparatus for handling

stochasticdifferentialequations (StroockandVaradhan,1987).
Amongst the problems on which Merton worked, both with
Samuelson and independently, was warrantpricing,and theresultantwork
formed two of the five chapters of his September 1970 PhD thesis
(Samuelson and Merton, 1969; Merton, 1970: chapters4 and 5). Black
and Scholes read the 1969 paper in which Samuelson and Merton de-
scribedtheirjointwork,but did not immediatelytell themof the progress
theyhad made: therewas 'friendlyrivalrybetweenthe two teams', says
Scholes (1998: 483). In the earlyautumnof 1970, however,Scholes did
discusswithMertonhis workwithBlack. Mertonimmediately appreciated
that this workwas a 'significant"break-through" ' (Merton, 1973: 142),
and it was Merton, for example, who christenedequation 4 the 'Black-
Scholes' equation. Given Merton's criticalattitudeto the Capital Asset
PricingModel, however,it is also not surprisingthathe also believedthat
'such an importantresult deserves a rigorousderivation',not just the
'intuitivelyappealing'one Black and Scholes had provided(Merton, 1973:
161-62). 'What I sort of argued with them [Black and Scholes]', says
Merton,'was, ifit depended on the [Capital] Asset PricingModel, whyis
it when you look at the final formula [equation 4] nothingabout risk
appears at all? In fact,it's perfectlyconsistentwith a risk-neutralworld'
[Mertoninterview].
So Merton set to workapplyinghis continuous-timemodel and Ito
calculus to theBlack-Scholeshedgedportfolio.'I looked at thisthing',says
Merton, 'and I realized that if you did ... dynamictrading ... if you
actually[traded]literallycontinuously, thenin fact,yeah,you could getrid
of the risk,but not just the systematicrisk,all the risk'.Not onlydid the
hedged portfoliohave zero [ in the continuous-time limit(Merton'sinitial
doubts on thispointwere assuaged),19'but you actuallyget a zero sigma':
that is, no variance of returnon the hedged portfolio.So the hedged
portfoliocan earn onlythe risklessrate of interest,'not forthe reason of
[the Capital] Asset PricingModel but ... to avoid arbitrage,or money
machine': a way of generatingcertain profitswith no net investment
[Merton interview].For Merton, then, the 'key to the Black-Scholes
analysis' was an assumptionBlack and Scholes did not initiallymake:
continuous trading,the capacity to adjust a portfolioat all times and
instantaneously. '[O]nly in the instantaneouslimitare the warrantprice
and stockprice perfectly correlated,whichis whatis requiredto formthe
"perfect"hedge' (Merton, 1972: 38).
Black and Scholes were not initiallyconvincedof the correctnessof
Merton's approach. Merton's additionalassumption- his world of con-
tinuous-timetrading- was a radical abstraction,and in a January1971
draftof theirpaper on optionpricingBlack and Scholes even claimedthat
equilibriumprices in capital marketscould not have characteristicsas-
sumed by Merton's analysis(Black and Scholes, 1971: 20). Merton, in
turn,told FischerBlack in a 1972 letterthat'I ... do not understandyour
reluctance to accept that the standard form of CAPM [Capital Asset

PricingModel] just does not work'(Merton, 1972). Despite thisdisagree-

ment,Black and Scholes used whatwas essentiallyMerton's revisedform
of theirderivationin the final,publishedversionof theirpaper (Black and
Scholes, 1973), though they also presentedBlack's originalderivation,
whichdrew directlyon the Capital Asset PricingModel. Black, however,
remainedambivalentabout Merton'sderivation,tellinga 1989 interviewer
that'I'm stillmore fond' of the Capital Asset PricingModel derivation:
'[T]here maybe reasonswhyarbitrageis not practical,forexampletrading
costs'. (If tradingincurseventinytransactioncosts,continuousadjustment
of a portfoliois infeasible.)Merton's derivation'is more intellectual[ly]
elegantbut it relies on stricterassumptions,so I don't thinkit's reallyas
robust'20
Black, indeed,came to expressdoubts even about the centralintuition
of orthodoxfinancialeconomics,that modern capital marketswere effi-
cient (in otherwords thatprices in themincorporateall knowninforma-
tion). Efficiencyheld, he suggested,only in a diluted sense: 'we might
definean efficientmarketas one in which price is withina factorof 2
of value'. Black noted thatthispositionwas intermediatebetweenthatof
Merton,who defendedthe efficient markethypothesis,and thatof'behav-
ioural' financetheoristRobert Shiller: 'Deviations fromefficiency seem
moresignificant in myworldthanin Merton's,but muchless significant in
my world than in Shiller's' (Black, 1986: 533; see Merton, 1987 and
Shiller,1989).
The Equation and the World

It was not immediatelyobviousto all thatwhatBlack, Scholes and Merton
had done was a fundamentalbreakthrough. The JournalofPoliticalEcon-
omyoriginallyrejectedBlack and Scholes' paper because, its editortold
Black, optionpricingwas too specializeda topic to meritpublicationin a
generaleconomicjournal (Gordon, 1970), and thepaper was also rejected
by the ReviewofEconomicsand Statistics(Scholes, 1997: 484). True, the
emergingnew breed of financialeconomistsquicklysaw the elegance of
theBlack-Scholessolution.All theparametersin equations4 and 5 seemed
readilyobservableempirically:therewere none of the intractableestima-
tion problemsof earliertheoreticalsolutions.That alone, however,does
not account forthe wider impact of the Black-Scholes-Mertonwork. It
does not explain, for example, how a paper originallyrejected by an
economicjournalas too specializedshouldwin a Nobel prizein economics
(Scholes and Merton were awarded the prize in 1997; Black died in
1995).
That the world came to embrace the Black-Scholes equation was in
part because the worldwas changing- see the remarksat the startof the
paper on the transformation of academic finance and the profession-
alizationofUS businessschools- and in partbecause theequation (unlike,
forexample,Bachelier'swork)changedtheworld.2'Thelatterwas the case
in four senses. First, the Black-Scholes equation seems to have altered

patterns of option prices. After constructingtheir call-option pricing

formula(equation 5 above), Black and Scholes testedits empiricalvalidity
forthe ad hoc NewYork optionsmarket,usinga broker'sdiariesin which
were'recordedall optioncontractswrittenforhis customers'.They found
only an approximatefit:'in generalwriters[the sellersof options] obtain
favorableprices, and ... there tends to be a systematicmispricingof
options as a functionof the varianceof returnsof the stock' (Black and
Scholes, 1972: 403, 413). A moreorganized,continuousoptionsexchange
was establishedin Chicago in 1973, but Scholes' studentDan Galai also
found that prices thereinitiallydifferedfromthe Black-Scholes model,
indeed to a greaterextentthanin the New Yorkmarket(Galai, 1977).
By the second half of the 1970s, however,discrepanciesbetween
patternsof optionpricingin Chicago and theBlack-Scholesmodel dimini-
shed to the pointof economicinsignificance (the ad hoc NewYorkmarket
quicklywitheredafterChicago and other organized options exchanges
opened). The reasons are various,but theyinclude the use of the Black-
Scholes model as a guide to arbitrage.Black set up a servicesellingsheets
of theoreticaloptionpricesto marketparticipants(see Figure 2). Options
marketmakerstused those sheets and othermaterialexemplifications of
the Black-Scholes model to identifyrelativelyover-pricedand under-
pricedoptionson the same stock,sold theformerand hedged theirriskby
buyingthelatter.In so doing,theyalteredpatternsofpricingin a waythat
increasedthe validityof the model's predictions,in particularhelpingthe
model to pass its key econometrictest: that the impliedvolatilityt of all
options on the same stock with the same expirationshould be identical
(MacKenzie and Millo, forthcoming).
The second world-changing,performativeaspect of the Black-
Scholes-Mertonworkwas deeper than its use in arbitrage.In its math-
ematicalassumptions,the equation embodied a world,so to speak. (From
this viewpoint,the differencesbetween the Black-Scholes world and
Merton's worldare less importantthan theircommonalities.)In the final
publishedversionof theiroptionpricingpaper in 1973, Black and Scholes
spelled out these assumptions,whichincludednot just the basic assump-
tionthatthe'stockpricefollowsa [lognormal]randomwalkin continuous
time', but also assumptionsabout marketconditions:that thereare 'no
transactioncosts in buyingor sellingthe stock or the option'; that it is
'possible to borrowany fractionof the price of a securityto buy it or to
hold it', at the risklessrate of interest;and that these are 'no penalties
to shortselling'(Black and Scholes, 1973: 640).
In 1973, these assumptions about market conditions were wildly
unrealistic.Commissions (a key transactioncost) were high everywhere.
Investorscould not purchasestockentirelyon credit- in theUSA thiswas
banned by the Federal Reserve'sfamous'RegulationT' - and such loans
would be at a rateofinterestin excess oftherisklessrate.Shortsellingwas
legallyconstrainedand financiallypenalized: stock lenders retainedthe
proceedsof a shortsale as collateralfortheloan, and refusedto pass on all

MacKenzie: An Equation and itsWorlds 853
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(or sometimes any) of the interestearned on those proceeds [Thorp

interview].
Since 1973, however,the Black-Scholes-Merton assumptionshave
become, while still not completelyrealistic,a great deal more so (see
MacKenzie and Millo, forthcoming).In listingthese assumptions,Black
and Scholes wrote:'we willassume "ideal conditions"in themarketforthe
stockand fortheoption' (Black and Scholes, 1973: 640). Of course,'ideal'
here means simplifiedand thus mathematically tractable,like the physi-
surface:
cist's frictionless non-zero transactioncosts and constraintson
borrowingand shortsellinghugely complicate the optionpricingproblem.
'Ideal', however,also connotes the way thingsought to be. This was not
Black and Scholes' intendedimplication:neitherwas an activistin relation
to the politics of markets.From the early 1970s onwards,however,an
increasingly influentialnumberof economistsand otherswereactivistsfor
the 'freemarket'ideal.
Their activities(along withotherfactors,such as the role of techno-
logical change in reducing transactioncosts) helped make the world
embodiedin the Black-Scholes-Mertonassumptionsabout marketcondi-
tions more real. The Black-Scholes-Merton analysis itselfassisted this
processby helpingto legitimizeoptionstradingand thushelpingto create
the efficient,liquid marketsposited by the model. The Chicago Board
Options Exchange'scounsel recalls:
Black-Scholes was reallywhat enabled the exchange to thrive.... [I]t
gave a lot of legitimacyto the whole notions of hedging and efficient
pricing,whereaswe werefaced,in the late 60s-early70s withthe issue of
gambling.That issue fell away, and I thinkBlack-Scholes made it fall
away.It wasn'tspeculationor gambling,itwas efficient
pricing.I thinkthe
SEC [Securitiesand Exchange Commission] very quickly thoughtof
optionsas a usefulmechanismin the securitiesmarketsand it's probably
- that'smy judgement- the effectsof Black-Scholes. I neverheard the
word'gambling'again in relationto options. [Rissmaninterview]
The Black-Scholes-Mertonmodel also had more specificimpactson the

natureof the marketsit analysed.Earlierupsurgesof optionstradinghad
typicallybeen reversed,arguablybecause option prices had usuallybeen
'too high' in the sense that theymade options a poor purchase: options
could too seldom be exercisedprofitably (Kairys and Valerio,1997). The
availabilityof the Black-Scholes formula,and its associatedhedgingtech-
niques, gave participants the confidenceto writeoptionsat lowerprices,
again helpingoptionsexchanges to grow and to prosper,becomingmore
likethemarketspositedby thetheory.The Black-Scholesanalysiswas also
used to freehedgingby options marketmakerstfromthe constraintsof
RegulationT. So long as theirstockpositionswereclose to the theoretical
hedging ratio ( ), theywere allowed to constructsuch hedges using
ax
entirelyborrowedfunds(Millo, forthcoming). direct
It was a delightfully
the model being used to make one of its key
loop of performativity:
assumptionsa reality.

Third, the Black-Scholes-Mertonsolutionto the problemof option

pricingbecame paradigmaticin the deeper Kuhnian sense of 'exemplary
solution'(Kuhn, 1970: 175), indeed moredeeplyso thanthe CapitalAsset
PricingModel. The Black-Scholes-Mertonanalysisprovideda range of
intellectualresourcesfor those tacklingproblems of pricingderivativest
of all kinds.Amongstthose resourceswerethe idea of perfecthedging(or
of a 'replicatingportfolio',a portfoliowhose returnswould exactlymatch
those of the derivativein all states of the world); no-arbitragepricing
(derivingprices fromthe argumentthatthe onlypatternsof pricingthat
can be stable are those thatgiverise to no arbitrageopportunities);and a
strikingexample of the use in economics of Ito's stochasticcalculus,
especiallyof the basic resultknownas 'Ito's lemma',the stochasticequiva-
lent of Taylor expansion,which serves interalia as a 'bridgingresult',
allowingthose trainedonlyin ordinarycalculus to performat least some
manipulationsin Ito calculus. Open anytextbookofmodernmathematical
finance(for example, Hull, 2000), and one findsmultipleuses of these
ideas. These uses are creativesolutionsto problems of sometimesgreat
difficulty,not rote applicationsof these ideas - a paradigmis a resource,
not a rule - but the familyresemblanceto the Black-Scholes-Merton
solutionis clear. In the words of optiontraderand theoristNassim Taleb,
far froman uncriticaladmirerof the Black-Scholes-Mertonwork,'most
everything thathas been developed in modern financesince 1973 is but
a footnote on the BSM [Black-Scholes-Merton] equation' (Taleb,
1998: 35).
The capacityto generatetheoreticalprices - not just forwhat soon
came to be called the 'vanilla' options analysed by Black, Scholes and
Mertonbut fora wide rangeof oftenexoticderivatives - playeda vitalrole
in the emergenceof the modern derivativesmarkets,especiallywhen, as
was thecase withtheoriginalBlack-Scholes-Mertonanalysis,thetheoreti-
cal argumentthatgeneratedpricesalso generatedrulesforhedgingtherisk
of involvementin such derivatives.I have already touched on the role
played by theoryin supportingthe emergenceand success of organized
options exchanges,but it was at least equally importantin the growthof
what is knownas the 'over-the-counter' (direct,institution-to-institution)
derivativesmarket,the overall volume of which is now larger. (In De-
cember 2002, the over-the-counter marketaccounted for85.6 percentof
total notionalvalue of derivativescontractsoutstandingglobally.22)Many
of the instrumentstraded in this market are highlyspecialized, and
sometimesno liquid market,or easilyobservablemarketprice, existsfor
them.However,boththevendorsofthem(mostusuallyinvestment banks)
and at least the more sophisticatedpurchasersof themcan oftencalculate
theoreticalprices, and thus have a benchmark'fair' price. The Black-
Scholes-Merton analysis and subsequent developmentsof it are also
centralto the capacityof an investmentbank to operateat large scale in
thismarket.They enable the risksinvolvedin derivativesportfoliosto be
decomposed mathematically. Many of these risksare mutuallyoffsetting,
so the residual risk that requires to be hedged is often quite small in

relationto the overallportfolio.Major investment banks can thus'operate

on such a scale thattheycan provideliquidityas iftheyhad no transaction
costs' (Taleb, 1998: 36).23 So the Black-Scholes-Mertonassumptionof
zero transactioncosts is now close to trueformajorinvestment banks- in
part because the use of thattheoryand its developmentsby those banks
allow them to manage theirportfoliosin a way which minimizestrans-
action costs.
Fourth, option pricingtheoryallowed a reconceptualizationof risk
that is only beginningto be recognizedin the burgeoningliteratureon
'risksociety'.24
Since 1973, a wide rangeof situationsinvolvinguncertainty
have been reconceptualizedas involvingimplicitoptions.Closest to tradi-
tional financeis the applicationof option theoryto corporateliabilities
such as bonds. Black and Scholes (1973: 649-52) pointedout thatwhena
corporation'sbonds matureits shareholderscan eitherrepaythe principal
(and own the corporationfreeofbond liabilities)or default(and thuspass
the corporation'sassets to the bond holders). A corporation'sbond
holdershave thusin effectsold a call optionto its shareholders. This kind
of reasoningallows, for example, calculation of implicitprobabilitiesof
bankruptcy.More generally,manyinsurancecontractshave at least some
of the structureof put options,and thisway of thinkinghas facilitatedthe
growingintegration ofinsuranceand derivatives trading(such as thesale of
'hurricanebonds' as a marketizedformof reinsurance).Even areas thatat
firstsight seem unlikelycandidates for rethinkingas involvingimplicit
options have been conceptualizedin this way: for example, professorial
tenure,pharmaceuticalsinnovation,and decisionsabout theproductionof
filmsequels (Merton, 1998). In the case of filmsequels, forinstance,it is
cheaperto make a sequel at the same timeas the original,but postponing
the sequel grantsa valuable option not to make it: option theorycan be
used to calculate which is better.Option pricingtheoryhas alteredhow
riskis conceptualized,by practitioners as well as by theorists.
Conclusion: Bricolage, Exemplars, Disunity and

Performativity
The importanceof bricolage in the historyof option pricing theory,
especiallyin Black and Scholes' work,is clear.They followedno rules,no
set methodology,but workedin a creativelyad hoc fashion.Their math-
ematicalworkcan indeed be seen as Lynch's'particularcourses of action
with materials at hand' (Lynch, 1985: 5) - in this case, conceptual
materials.Consider, for example, Black and Scholes' use of Sprenkle's
work.The latterwould ratescarcelya mentionin a 'Whig' historyofoption
pricing:his model is, forexample,dismissedin a footnotein Sullivanand
Weithers'historyas possessing'seriousdrawbacks'(Sullivanand Weithers,
1994: 41). True, centralto Sprenkle'sworkwas the hope that analysing
option pricingwould revealinvestors'attitudesto risk,a goal thatin the
Black-Scholes-Mertonanalysis(whichimpliesthatoptionsare pricedas if
all investorsare entirelyrisk-neutral)is not achievable.Yet, as we have

seen, Black and Scholes' tinkeringwith Sprenkle'sequation was the key

step in theirfindinga solutionto theirdifferential
equation,and 'tinkering'
is indeed the rightword.25
It was, however,tinkeringinspiredby an exemplar,the Capital Asset
PricingModel. Here, the contrastwithThorp is revealing.He was far
better-trainedmathematicallythan Black and Scholes were, and had
extensiveexperienceof tradingoptions (especiallywarrants),when they
had nextto none. He and Kassouf also conceivedof a hedged portfolioof
stock and options (with the same hedgingratio,-W), and they,unlike
ax
Black and Scholes,had implementedapproximations to such hedgedport-
foliosin theirinvestmentpractice.Thorp had even tinkeredin essentially
the same way as Black and Scholes with an equation equivalent to
Sprenkle's(equation 1 above). But while Black and Scholes were trying
to solve the optionpricingproblemby applyingthe Capital Asset Pricing
Model, Thorp had littleinterestin thelatter:he was awareofit,but not 'at
the expertlevel'.26Indeed,forhim the proposition(centralto the mathe-
maticsof Black and Scholes, and in a different wayto Merton'sanalysisas
well) that a properlyhedged portfoliocould earn only the risklessrate
would have stood in directcontradictionto his empiricalexperience.He
and Kassouf were regularlyearningfarmore than thatfromtheirhedged
portfolios.
For Thorp, then,to have put forwardBlack and Scholes' or Merton's
centralargumentwould have involvedoverriding whathe knewof empiri-
cal reality.For Scholes (trainedas he was in Chicago economics),and even
forBlack (despitehis doubtsas to thepreciseextentto whichmarketswere
efficient),it was reasonable to postulate that marketswould not allow
money-making opportunitieslike a zero-3 (or, in Merton's version,zero-
risk)portfoliothatearnedmorethantherisklessrate.Thorp,however,was
equally convinced that such opportunitiescouldbe found in the capital
markets.The 'conventionalwisdom' had been that'you couldn't beat the
casino': in the terminologyof economics,that 'the casino marketswere
efficient'.
Thorp had showed this was not true,'so whyshould I believe
these people who are sayingthe financialmarketsare efficient?'[Thorp
interview].
Theoretical commitmentwas thus importantto the developmentof
option pricing. It was not, however,commitmentto the literal truth
of economics'models. Black and Scholes, forexample,knew(indeed,they
showed: see Black et al., 1972) that the Capital Asset PricingModel's
empiricalaccuracy was questionable.That, however,did not stop them
regardingthe model as identifying an economic process of great im-
portance. Nor, crucially,did it deter them fromusing the model as a
resourcewithwhichto solvethe optionpricingproblem.Similarly, neither
they,nor Merton, mistook their option model for a representationof
reality.Black, forexample,delightedin pointingout 'The Holes in Black-
Scholes' (Black, 1988): economicallyconsequential ways in which the
model's assumptionswere unrealistic.For Black, Scholes and Merton -

like the economistsstudiedbyYonayand Breslau (2001) - a model had to

be simple enough to be mathematicallytractable,yet rich enough to
capture the economicallymost importantaspects of the situationsmod-
elled. Models were resources,not (in any simple sense) representations:
ways of understandingand reasoning about economic processes, not
putativedescriptionsof reality.If the latteris the criterionof truth,all of
the financialeconomistsdiscussed here would agree withtheircolleague
Eugene Fama thatanymodel is 'surelyfalse' (Fama, 1991: 1590).
Nor were the theoreticalinspirationsand commitmentsof option
pricingtheoristsunitary.Black-Scholes-Mertonoption pricingtheoryis
centralto the 'orthodox'modern economic analysisof financialmarkets.
But that does not mean that Black, Scholes and Merton adhered to the
same theoreticalviewpoint.They disagreed,forexample,on thevalidityof
the originalformof the Capital Asset PricingModel. As we have seen,
Merton consideredthe originalderivationsof the Black-Scholes equation
unrigorous;Black remained to a degree a sceptic as to the virtuesof
Merton's derivation.Nor did thiskind of disagreementend in 1973. For
example,to Michael Harrison,an operationsresearcher(and essentiallyan
applied mathematician)at StanfordUniversity, the entirebody of workin
option pricingtheorypriorto the mid-1970s was insufficiently rigorous.
Harrison and his colleague David Kreps asked themselves,'Is there a
Black-Scholestheorem?'From theviewpointofthe'theorem-proof culture
... I [Harrison]was immersedin' [Harrisoninterview]therewas not. So
theyset to workto formulateand prove such a theorem,a process that
eventuallybroughtto bear modern 'Strasbourg' martingaletheory(an
advanced and previouslya rather'pure' area of probabilitytheory).27
Divergencesof thiskindmightseem to be a sourceofweakness.In the
case of optionpricingtheory,however,theyare a source of strength, even
more directlyso thanin the more generalcase discussedby Mirowskiand
Hands (1998). If the Black-Scholes equationcould be derivedin onlyone
way, it would be a fragilepiece of reasoning.But it can be derivedin
several: not just in the varietyof ways described above, but also, for
example, as a limit case of the later finite-timeCox-Ross-Rubinstein
model (Cox et al., 1979).Plug the log-normalrandom walk and the
specificfeaturesof option contractsinto Harrisonand Kreps' martingale
model, and Black-Scholes again emerges.Diversityindeed yieldsrobust-
ness. For example, as Black pointed out, defendingthe virtuesof the
originalderivationfromthe Capital Asset PricingModel, thatderivation
'might still go through'even if the assumptionsof the arbitrage-based
derivationfailed.28
This richdiversity ofwaysof derivingthe Black-Scholesequationmay
promptin the reader a profoundlyunsociologicalthought:perhaps the
equation is simplytrue?This is wherethisarticle'sfinaltheme,performa-
tivity,is relevant.As an empiricaldescriptionofpatternsof optionpricing,
the equation startedout as onlya roughapproximation, but thenpricing
patternsalteredin a waythatmade it moretrue.In part,thiswas because
theequationwas used in arbitrage.In part,it was because thehypothetical

world embedded in the equation (perhaps especiallyin Merton's con-

tinuous-timederivationof it) has been becomingmore real, at least in the
core marketsof the Euro-Americanworld.As Robert C. Merton, in this
contextappropriately the son of RobertK. Merton (withhis sensitivity to
the dialectic of the social world and knowledgeof that world), puts it,
'realitywill eventuallyimitatetheory'(Merton, 1992: 470; see Merton,
1936, 1949).
Perhaps, though, the reader's suspicion remains: that this talk of
performativity is justa fancywayofsayingthattheBlack-Scholesequation
is the correctwayto price options,but marketpractitioners onlygradually
learned that. Not so. The phase of increasingempiricalaccuracy of the
Black-Scholesequationhas been followedby a phase, since 1987, in which
the fitof the empiricalpricesto the model has again deteriorated(Rubin-
stein, 1994). One way of expressingthispartialbreakdownafter1987 of
the performativity of classic option theoryis to note thatwhile,as noted
above, some of its assumptionshave become moretrue (in partbecause of
feedback loops from the theory),this has not been the case for the
assumptionof the log-normality of the pricemovementsof stocksor other
underlyingassets.The giganticone-dayfallof the US stockmarketon 19
October 1987 was a grotesquelyunlikelyeventon the assumptionof log-
normality:forexample,Jackwerth and Rubinstein(1996: 1612) calculate
the probabilityon thatassumptionof the actual fallin S&P index futures
as 10-160. In addition, 19 October was far more than the disembodied
rejectionof the null hypothesisof log-normality. The fall in stock prices
came close to settingoffa chain of market-maker bankruptciesthatwould
have threatenedthe veryexistenceof organizedderivativesexchangesin
the USA. The subsequentsystematic departurefromBlack-Scholesoption
pricing- the so-called 'volatilityskew'29- is more than a mathematical
adjustmentto empiricaldeparturesfromlog-normality: it is too largefully
to be accountedforin thatway (Jackwerth, 2000). It can in a sense be seen
as the optionsmarket'scollectivedefencemechanismagainstsystemicrisk
(MacKenzie and Millo, forthcoming).
More generally,marketpractitioners'adoption of financialeconomics
has not renderedfullyperformative economics' pervasive,oftenimplicit,
underlyingassumption of rational egoism. Pace Callon (1998), homo
ceconomicus has not in generalbeen broughtfullyinto being.What has not
to date been grasped in the debate over economics' performativity (for
exampleMiller,2002) is thatthereexistsa reasonablypreciseprobe as to
whetheror not actors have been configuredinto hominesceconomici: col-
lectiveaction,in otherwordsactionthatadvancesthe interestsof an entire
group but in regardto which the rationalegoistwill free-ride.(A classic
exampleof collectiveactionis blood donationin a countrysuch as theUK
where such donation is unremunerated[Titmus, 1970]. Well-stocked
blood banks are in the collectiveinterestof the entirepopulation of the
UK, but a rationalegoistwould nonethelessbe unlikelyto donate blood
because the minorinconvenienceand discomfortinvolvedwould almost
certainlyoutweighthe minisculeprobabilityof benefiting personallyfrom

his or herown donation.)As the analysisby Olson (1980) famouslyshows,

ifall actorsare homines ceconomicitheywill all free-ridein such a situation,
and collectiveactionwill therefore be impossible.
However, participantsin financialmarketshave, at least to some
extent,retainedthe capacityforcollectiveaction.The verycreationof the
Chicago Board OptionsExchange,whichset in trainthekeyprocessesthat
have rendered option theoryperformative, involved donations of un-
remuneratedtime that were structurally akin to blood donation (Mac-
Kenzie and Millo, forthcoming). The classic social networkanalysis of
option pricingby Baker (1984) can, likewise,be read as showingthe
persistence,at leastin CBOE's smallertradingcrowds,ofcollectiveaction,
and, as noted above, the volatilityskew can also be interpreted, at least
tentatively,as collectiveaction.
The analysisof economics'performativity does not point,therefore, to
the smoothlyperformedworld fearedby Callon's criticssuch as Miller
(2002). It points to contestedterrain.When, in 1968, David Durand, a
leadingfigurein theolderformoftheacademic studyoffinance,inspected
the mathematicalmodels that were beginningto transformhis field,he
commentedthat'The new financemen ... have lost virtuallyall contact
withterrafirma'(Durand, 1968: 848). As we have seen, the decades since
1968 have seen the world of finance change in such a way that the
apparentlyungroundedmodels thathorrifiedDurand have gained verisi-
militudeas theyhave become incorporatedinto the structuresand prac-
ticesof markets.However,the financialmarketsremain,and I suspectwill
alwaysremain,an onlypartiallyconfiguredworld.The strugglesto con-
figurethatworld,and theforcesopposingand underminingthatconfigur-
ing, are, and will remain,at the heartof thehistoryof our times.
List of Interviews
Fama, Eugene, interviewedby author,Chicago, 5 November1999.
Harrison,J.Michael, interviewedby author,Stanford,CA, 8 October 2001.
Kassouf, Sheen, interviewedby author,NewportBeach, CA, 3 October 2001.
Merton,RobertC., interviewedby author,Cambridge,MA, 2 November1999.
Miller,Merton,interviewedby author,Chicago, 5 November1999.
Rissman,Burton,interviewedby author,Chicago, 9 November1999.
Samuelson,Paul A., interviewedby author,Cambridge,MA, 3 November1999.
Scholes, MyronS., interviewedby author,San Francisco,CA, 15 June2000.
Sprenkle,Case M., interviewedby authorby telephoneto Champaign,IL, 16 October
2002.
Thorp, Edward O., interviewedby author,NewportBeach, CA, 1 October 2001.
Treynor,Jack,interviewedby author,Palos VerdesEstates,CA, 3 October 2001.
Notes
I am extremely Mrs CatherineBlack and the Institute
gratefulto all the above interviewees.
Archivesand Special Collections,MIT, kindlygave me access to the FischerBlack papers.
Otherunpublishedmaterialwas generouslyprovidedby PerryMehrlingand Mark
Rubinstein,and I am gratefulto EdwardThorp, Sheen Kassouf and Random House, Inc.
forpermissionto reproduceFigure 1. Helpfulcommentson the firstdraftof thisarticle
werereceivedfromSocial StudiesofScience'sreferees,fromSheen Kassouf,William

Margabe, PerryMehrling,and Esther-MirjamSent, and froma workshopon social studies

of financeheld in Konstanz, 15-18 May 2003. The researchwas fundedby DIRC, the
Interdisciplinary Research Collaborationon the Dependabilityof Computer-BasedSystems
(UK Engineeringand PhysicalSciences ResearchCouncil grantGRIN13999) and by the
InitiativesFund of the Universityof Edinburgh'sFacultyGroup of Social Sciences and
Law. It is being continuedwiththe assistanceof a professorialfellowshipawardedby the
UK Economic and Social Research Council.
1. See, forexample,Klaes (2000), Mirowski(1989 and 2002), Sent (1998), Weintraub
(1991), Yonay (1994),Yonay and Breslau (2001).
2. Examples include Izquierdo (1998, 2001), Knorr Cetina and Bruegger(2002), Lepinay
(2000), Lepinay and Rousseau (2000), MacKenzie (2001), Millo (forthcoming),
Muniesa (2000), Preda (2002). This body of workinteractswitha pre-existing tradition
of the sociologyand anthropologyof financialmarkets,such as Abolafia(1996, 1998),
Baker (1984), Hertz (1998), Smith(1999).
3. Data fromBank forInternationalSettlement,www.bis.org. These figuresare adjusted
forthe most obvious formsof double-counting,but stillarguablyexaggeratethe
economic significanceof derivativesmarkets.Swaps, forexample,are measuredby
notionalprincipal,when thisis not in factexchanged.See also note 22 below.
4. Aside fromthe recollectionsof Black and Scholes themselves(Black, 1989; Scholes,
1998), the main existinghistoryis Bernstein(1992: chapter11), whicheschews
detailedmathematicalexposition.More mathematical,but unfortunately somewhat
Whiggish(see below), is Sullivanand Weithers(1994).
5. Bricoleuris Frenchforodd-job person. Levi-Strauss(1966) introducedtheAnglo-
Saxon social sciencesto the metaphor.Its appropriatenessto describescience is argued
in Barnes (1974, chapter3).
6. 'Contango' was the premiumpaid by the purchaserof a securityto its sellerin return
forpostponingpaymentfromone settlementdate to the next.
7. Bachelier(1900: 21, 35, 37); the quotationsare fromthe Englishtranslation
(Bachelier,1964: 17, 28-29, 31). In the Frenchmarketstudiedby Bachelier,option
priceswerefixedand strikepricesvariable(the reverseof the situationstudiedby the
Americanauthorsdiscussedbelow), hence Bachelier'sinterestin the determination of
strikepricesratherthan optionprices.
8. Interviewsby the authordrawnon in thispaper are listedas an appendix
9. Readers of Galison (1997) will not be surprisedto discoverthereare deep issues here
as to the meaningof 'random',in particularas to the precisenatureof the stochastic
dynamicsof stockprices.Unfortunately, these cannotbe discussedhere.
10. To avoid confusion,I have made minoralterations(e.g. interchanging letters)to the
notationused by the authorswhose workis described,and have sometimesslightly
rearrangedthe termsin equations.More substantialdifferences betweentheir
mathematicalapproachesare preserved.
11. Stock price 'trend'was measuredby 'the ratioof the presentprice to the averageof the
year'shighand low' (Kassouf, 1965: 50).
12. The curvesare of course specificto an individualwarrant,but as well as providingtheir
readerswithKassouf's formulaforcalculatingthem,Thorp and Kassouf (1967: 78-79)
providedstandardized'average' curvesbased on the prices of 1964-66.
13. As Thorp explained(Thorp, 1973: 526), 'to sell warrantsshort[and] buy stocks,and
yetachievethe risklessrate of returnrequiresa higherwarrantshortsale price than for
the correspondingcall [option]' underthe Black-Scholesassumptions.Thorp had also
been sellingoptionsin the NewYork market,wherethe sellerdid receivethe sale price
immediately(minus'margin'retainedby the broker),but the price discrepancieshe
was exploitingweregross (so grosshe feltable to proceed withouthedgingin stock),
and thusthe requisitediscountfactorwas not a salientconsideration.
14. See Treynor(1962). The datingof thisunpublishedpaper followsa private
communicationto the authorfromJackTreynor,4 March 2003. See also Lintner
(1965), Mossin (1966), Sharpe (1964). Treynor'stypescript draftwas eventually
publishedas Treynor(1999).

15. Treynorinterview;Black (1989: 5). Treynorand Black did not publishtheirwork

immediately:it eventuallyappeared in 1976. The correcteddifferential equation is
equation 2 of theirpaper (Treynorand Black, 1976: 323).
16. Unfortunately, I have been unable to locate anycontemporaneousdocumentaryrecord
of thisinitialphase of Black's workon optionpricing,and it maybe thatnone survives.
The earliestextantversionappears to date fromAugust 1970 (Black and Scholes,
1970a), and is in the personalfilesof Prof.StewartMyersat MIT (I am gratefulto
PerryMehrlingfora copy of thispaper). There is an October 1970 versionin Fischer
Black's papers (Black and Scholes, 1970b). Black's own account of the historyof
optionformula(Black, 1989: 5) containsonlya verbaldescriptionof the initial
phase of his work.It seems clear,however,thatwhatis being describedis the
'alternativederivation'of the Octoberpaper (Black and Scholes, 1970b: 10-12): the
main derivationin thatpaper and in Black and Scholes (1970a) is the hedged portfolio
derivationdescribedbelow,whichwas chronologically a laterdevelopment.
17. Thus in Black and Scholes (1970b: 8-9) theyshow thatthe covarianceof the hedged
portfoliowiththe overalllevel of the marketwas zero, assumingthatin small enough
timeintervalschangesin stockprice and in overallmarketlevelhave a jointnormal
distribution.Using theTaylorexpansionof w, Black and Scholes showedthatthe
I
covarianceof warrantprice changeswithmarketlevelchangesis: aawcov (zAx2,
z\m),where'cov' indicatescovarianceand A\m is the change in marketlevel.If A\x
and A\mare jointlynormallydistributedoversmall timeperiods,cov (zAx2,z\m)is the
covarianceof the square of a normalvariablewitha normalvariable,whichis always
zero.Witha zero covariancewiththe market,the hedged portfoliomust,accordingto
the Capital Asset PricingModel, earn the risklessrateof interest.
18. A quadraticutilityfunctionhas the formU(y) = I + my+ ny2, where1,m, and n are
constant:n mustbe negativeif,as willin generalbe the case, 'the investorprefers
smallerstandarddeviationto largerstandarddeviation(expectedreturnremainingthe
same)' (Markowitz,1959: 288), and negativen impliesthatabove a thresholdvalue
utilitywill diminishwithincreasingreturns.Markowitz'spositionis thatwhilequadratic
utilitycannotreasonablybe assumed,a quadraticfunctioncentredon expectedreturn
is a good approximationto a wide rangeof utilityfunctions:see Levy and Markowitz
(1979).
19. See note 17 above forhow Black and Scholes demonstratedI = 0 in the October 1970
versionof theirpaper.
20. FischerBlack interviewedby Zvi Bodie, July1989. I'm gratefulto Prof.Bodie fora
copy of the transcript of thisunpublishedinterview.
21. See Jarrow(1999), thoughJarrowhas in mind a sense of 'changed the world'weaker
thanperformativity.
22. Data fromBank forInternationalSettlements,www.bis.org.Many over-the-counter
derivativespositionsare closed out by enteringinto offsettingderivativescontracts,so
the comparisonprobablyoverstatesthe relativeimportanceof the over-the-counter
market,but it is nonethelesssubstantial.
23. See also Hull (2000: 54) on the extentto whichtypicalassumptionsof financetheory
are trueof major investment banks.
24. Beck (1992). For one of the fewtreatments bringingfinancialrisk(but not option
theory)into the discussion,see Green (2000).
25. It is used in a one-sentencesummaryof Black's own history(Black, 1989: 4), but the
summaryis probablyan editorialaddition,not Black's own.
26. Edward 0. Thorp, email messageto author,19 October 2001.
27. See Harrisonand Kreps (1979) and Harrisonand Pliska (1981). The firstderivationof
the Black-Scholes formulathatHarrisonand Kreps would allow as reasonablyrigorous
is in Merton (1977). This latterpaper explicitlyrespondsto queries thathad been
raisedabout the originalderivation.For example,Smith(1976: 23) had noted thatthe
optionprice,w,is, in the originalwork,assumed but not proved'to be twice
differentiable everywhere'.

28. FischerBlack interviewedby Zvi Bodie, July1989.

29. In the Black-Scholes-Mertonmodel, the relationshipof impliedtvolatility to
striket
price is a flatline. Since October 1987, however,the relationshiphas become
skewed,withoptionswithlow strikepriceshavinghigherimpliedvolatilitiesthanthose
withhigherstrikeprices (Rubinstein,1994). The optionmarkethas come to 'expect'
crashes,in otherwords.
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Donald MacKenzieholdsa personalchairin Sociologyat Edinburgh

wherehe has taughtsince1975. Hisfirstbook was Statistics
University, in
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(EdinburghUniversity
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Address:Schoolof Social & PoliticalStudies,University
of Edinburgh,
Adam
FergusonBuilding,EdinburghEH8 9LL,UK;email:D.MacKenzie@ed.ac.uk


Mackenzie Bricolage e Performatividade

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An Equation and Its Worlds: Bricolage, Exemplars, Disunity and Performativity in Financial

This content downloaded from 91.220.202.52 on Sat, 28 Jun 2014 07:26:27 AM

ABSTRACT Thispaperdescribesand analysesthe history of the fundamental

An Equation and its Worlds:

Economics and economiesare becominga majorfocusforsocial studiesof

Social StudiesofScience33/6(December 2003) 831-868

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This paper contributesto the emergentscience-studiesliteratureon

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- is the subject of a 'sister'paper (MacKenzie and Millo, forthcoming),

Arbitrage; arbitrageur Tradingthatseeks to profitfromprice discrepancies;a trader

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hand' (Lynch, 1985: 5). Whilethishas been documentedin overwhelming

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Economic 'orthodoxy'is a reality- attendconferencesof economistswho

Ratherthansayingit [neoclassicism]simplychased out the competition-

As we shall see, that general characterizationappears to hold for the

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remove the need for empirical examination.That the theory can be

'Too Much on Finance!'

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interval,howevershort,the value of x changedprobabilistically.

where H was a constant. (For the reader's convenience,notationused

(3 the covarianceof the price of an asset withthe generallevel of the market,dividedby

For itemsmarkedt see the glossaryin Table 1.

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at Besancon ratherthanin Paris - seems due in part to his

Option and Warrant Pricing in the 1950s and 1960s

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be worthlessifx* is below c, since exercisingthe warrantwould

Of course, the stockprice x* is not knownin advance, so to calculatethe

To evaluatethisintegral,Sprenkleassumed thatf(x*) was log-normal(by

ln(kx/c)+ s212 ln(kx/c)- s2/2

whereln is the abbreviationfornaturallogarithm,s2 is the varianceof the

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negativeone: thatis, a leveredassetwould have to offeran expectedrateof

ln(kxlc)+ s'12 ln(kxlc)- s'12

(The righthand side ofthisequationreducesto expression1 in thecase of

'The Greatest Gambling Game on Earth'

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estimate.An alternativeapproach was to eschew a priorimodels and to

seemed roughlyto fitobservedcurvilinearrelationshipsbetweenwarrant

wherez was an empirically-determined functionofthestockprice,exercise

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Thorp and Shannon's use of theirwearable roulettecomputerwas

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roughlyis at point (A,B) in Figure 1, the appropriatehedge ratiowas to

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making'- and in 1967 he startedto use it to identifygrosslyoverpriced

Black and Scholes

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makingtheirinvestmentdecisions.This was the problemthat had most

where Ax is the change in stock price over the interval.Black then

whereE designates'expectedvalue' and higherordertermsare dropped.

where r is the risklessrate of interestand o- the volatilityt

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In the autumn of 1968, however,Black (stillworkingforArthurD.

was the same conclusionThorp and Kassouf had arrivedat: aw is their

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Whilethe resultwas in thatsense equivalent,it was embeddedin quite

wherec is the strikeprice,o-the volatilityof the stock,t* the expirationof

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to do was show by differentiating