MacKenzie_jkt.qxd 3/30/06 1:27 PM Page 1 economics/science, technology, and society Donald MacKenzie is Professor of Sociology (Personal Chair) at the University of Edinburgh. He was the winner of the 2005 John Desmond Bernal Prize, awarded jointly by the Society for Social An Engine, Not a Camera Studies of Science and the Institute for Scientific Information, for career contributions to the field of science studies. His books “In one lifetime modern finance theory has revolutionized the arts of canny include Inventing Accuracy (1990), Knowing Machines (1996), and investing. MacKenzie knows this exciting story, and he tells it well.” How Financial Models Shape Markets Mechanizing Proof (2001), all published by The MIT Press. Portions Paul A. Samuelson, MIT, Nobel Laureate in Economic Sciences (1970) An Engine, Not a Camera of An Engine, Not a Camera won the Viviana A. Zelizer Prize in . economic sociology from the American Sociological Association. “Having returned from an audacious incursion into the black box of modern How Financial Models Shape Markets financial markets, Donald MacKenzie shows how economic theory has succeeded in capturing and shaping them. This book will be of substantial interest to specialists in a range of fields including economics, finance theory, Donald MacKenzie economic sociology, and science and technology studies. But MacKenzie’s tour An h de force is to make clear, even to nonspecialists, that through complex tech- Engine, DDoonnaallddMMaaccKKeennzziiee nical issues, alternative forms of economic organization can be imagined and Not a In An Engine, Not a Camera, Donald MacKenzie argues that the discussed.” Camera emergence of modern economic theories of finance affected Michel Callon, Ecole des Mines de Paris financial markets in fundamental ways. These new, Nobel Prize- Inside Technology series MacKenzie winning theories, based on elegant mathematical models of markets, were not simply external analyses but intrinsic parts of economic processes. “Donald MacKenzie has long been one of the world’s most brilliant social Paraphrasing Milton Friedman, MacKenzie says that economic and historical analysts of science and technology. Here he provides an original, models are an engine of inquiry rather than a camera to reproduce astute, and exhaustively researched account of the development of finance empirical facts. More than that, the emergence of an authoritative theory and the ways in which it is intertwined with financial markets. An theory of financial markets altered those markets fundamentally. Engine, Not a Camera is essential for anyone interested in markets and the For example, in 1970 there was almost no trading in financial forms of knowledge deployed in them.” derivatives such as “futures.” By June of 2004, derivatives contracts Karin Knorr Cetina, University of Konstanz and University of Chicago totaling $273 trillion were outstanding worldwide. MacKenzie suggests that this growth could never have happened without the “An Engine, Not a Camera is a compelling, detailed, and elegantly written explo- development of theories that gave derivatives legitimacy and ration of the conditions in which finance economists help to make the world explained their complexities. they seek to describe and predict. Donald MacKenzie has long been without MacKenzie examines the role played by finance theory in the equal as a sociologist of how late modern futures are brought into being and two most serious crises to hit the world’s financial markets in made authoritative. This is his best work yet.” recent years: the stock market crash of 1987 and the market Steven Shapin, Franklin L. Ford Professor of the History of Science, turmoil that engulfed the hedge fund Long-Term Capital Harvard University Management in 1998. He also looks at finance theory that is somewhat beyond the mainstream—chaos theorist Benoit The MIT Press | Massachusetts Institute of Technology | Cambridge, Massachusetts 02142 Mandelbrot’s model of “wild” randomness. MacKenzie’s pioneering Cover image: Traders on the floor of work in the social studies of finance will interest anyone who the Chicago Board Options Exchange, http://mitpress.mit.edu | 0-262-13460-8 October 19, 1987. Photograph by wants to understand how America’s financial markets have John T. Gralak. © Corbis. All rights grown into their current form. reserved. An Engine, Not a Camera Inside Technology edited by Wiebe E. Bijker, W. Bernard Carlson, and Trevor Pinch A list of the series will be found on page 369. An Engine, Not a Camera How Financial Models Shape Markets Donald MacKenzie The MIT Press Cambridge, Massachusetts London, England © 2006 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. This book does not constitute financial advice, and it is sold with the understanding that neither the author nor the publisher is engaged in rendering investing, legal, accounting, or other professional service. If investment advice or other expert assis- tance is required, the services of a competent professional person should be sought. MIT Press books may be purchased at special quantity discounts for business or sales promotional use. For information, please email [email protected] or write to Special Sales Department, The MIT Press, 55 Hayward Street, Cambridge, MA 02142. Set in Baskerville by SNP Best-set Typesetter Ltd., Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data MacKenzie, Donald A. An engine, not a camera : how financial models shape markets / Donald MacKenzie. p. cm. — (Inside technology) Includes bibliographical references and index. ISBN 0-262-13460-8 1. Capital market—Mathematical models. 2. Derivative securities—Mathematical models. 3. Financial crises—Mathematical models. 4. Financial crises—Case studies. I. Title. II. Series. HG4523.M24 2006 332'.01'5195—dc22 2005052115 10987654321 to Iain Contents Acknowledgements ix 1 Performing Theory? 1 2 Transforming Finance 37 3 Theory and Practice 69 4 Tests, Anomalies, and Monsters 89 5 Pricing Options 119 6 Pits, Bodies, and Theorems 143 7 The Fall 179 8 Arbitrage 211 9 Models and Markets 243 Appendix A An Example of Modigliani and Miller’s “Arbitrage Proof” of the Irrelevance of Capital Structure to Total Market Value 277 viii Contents Appendix B Lévy Distributions 279 Appendix C Sprenkle’s and Kassouf’s Equations for Warrant Prices 281 Appendix D The Black-Scholes Equation for a European Option on a Non- Dividend-Bearing Stock 283 Appendix E Pricing Options in a Binomial World 285 Appendix F Repo, Haircuts, and Reverse Repo 289 Appendix G A Typical Swap-Spread Arbitrage Trade 291 Appendix H List of Interviewees 293 Glossary 297 Notes 303 Sources of Unpublished Documents 331 References 333 Series List 369 Index 371 Acknowledgements To research and to write a book is to incur a multitude of debts of gratitude. For an academic, time is often the resource in shortest supply. The time needed to write this book and to complete the research that underpins it was provided by a professorial fellowship awarded by the U.K. Economic and Social Research Council (RES-051-27-0062). The funds for the trips required by all but the most recent interviews were provided by Edinburgh University and especially by the Interdisciplinary Research Collaboration on the Depend- ability of Computer-Based Systems (DIRC), which is itself supported by a grant awarded by the U.K. Engineering and Physical Sciences Research Council (GR/N13999). Behind that bald statement lies the generosity of DIRC’s overall director, Cliff Jones, and of the leaders of its Edinburgh center, Stuart Anderson and Robin Williams, in regarding an offbeat topic as relevant to DIRC. Robin, in particular, has been a good friend both to me and to this project. Ultimately, though, money was less important as a source of support than people. Moyra Forrest provided me, promptly and cheerfully, with the vast majority of the hundreds of documents that form this book’s bibliography. Margaret Robertson skillfully transcribed the bulk of the interviews: as anyone who has done similar work knows, the quality of transcription is a key matter. I am always amazed by Barbara Silander’s capacity to turn my voluminous, messy, handwritten drafts, heavily edited typescript, dictated passages, and file cards into an orderly word-processed text and reference list: I could not have written the book without her. I have also been lucky enough to find colleagues who have shared my enthu- siasm for “social studies of finance.” Yuval Millo was there at my project’s inception, and has contributed to it in a multitude of ways. James Clunie, Iain Hardie, Dave Leung, Lucia Siu, and Alex Preda have now joined me in the Edinburgh group, and it is my enormous good fortune to have them as collaborators. x Acknowledgements The work reported here draws heavily upon what I learned from the many interviewees from finance theory and the financial markets whose names are listed in appendix H (and by some additional interviewees who preferred anonymity). They gave their time to help me understand their world: if this book has virtues, it is largely as a result of their generosity in this respect. Peter Bernstein—who is both an investment practitioner and the author of the first overall history of finance theory (Bernstein 1992)—provided crucial advice and encouragement, as did Robert C. Merton. Particularly important in setting up in interviews for me and in putting me in touch with interviewees was Emily Schmitz of the Chicago Board Options Exchange: she is another person without whose help this book would have been much impoverished. Cathy Tawes Black kindly permitted me access to the papers of Fischer Black, held in the Institute Archives at the Massachusetts Institute of Technology. Several of the episodes discussed here have been controversial, some bitterly so.