Understanding the Market

At typical financial markets, traders make a market in financial instruments, such as corporate equity, government bonds and currencies.  But there are markets in many other items ranging from commdities (such as wheat and frozen pork bellies) to more conceptual items such as hurricanes or the number of jobs reported on the monthly Employment report.  Futures and options exchanges have rapidly expanded their product offerings in recent years (see here for a little history of the Chicago exchanges).

These markets have several roles; participants in the markets for these products can reduce their risk; a farmer can lock in a price for his crop at the start of the season or a manufacturing company can lock in a price for a particular commodity that it uses. But the futures price generated in these markets should be an accurate prediction of the price. Speculators should be willing to buy contracts when the futures price seems too low or sell contracts when the futures price seems too high, to profit from the expected price change; for example, suppose news comes about bad weather that will destroy a large part of the corn crop; speculators will start buying contracts until the price reflect the best expectation of the future price.  The logic is similar to the Delphi method (discussed here): a number of informed analysts will converge on the truth by pooling their information. In futures markets, the pooling is accomplished by allowing the analysts to trade and profit from their access to information or their ability to analyze it.

The University of Iowa became known for trading, among other things, presidential futures (see here for some history); on this market students trade “shares” of political candidates or parties. The market prices of the Iowa Election Market were fairly accurate forecasters of election results

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, even when compared to traditional polls (see here for some data). This prompted a great deal of interest in creating futures markets on many events, from sporting events to terrorist attacks (see here for an article about an unsuccessful proposal from the Pentagon).

Intrade is an Irish “incorporated service business” that allows the public to trade futures on many public events, ranging from the date of the capture of Osama bin Laden to the top marginal tax rate in the US in 2011.   These contracts are all of the “winner take all” variety; you can buy a contract on whether an event will occur and you receive $1 if you are correct and nothing if you are wrong. Below you can find the chart of the Obama and McCain contracts, that is contracts that will pay $1 if Obama or McCain is elected President.

INTRADE.COM Price for Obama to be elected President

INTRADE.COM Price for McCain to be elected President

At the time that I am writing (August 21)

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, Obama shares are trading around $.60 and McCain shares around $.40. These prices imply that in aggregate, traders believe that Obama has a 60% chance of winning the election and McCain 40% (these two numbers should add up to a bit less than one if there is a small chance that someone else will win; if the of total prices were greater than $1

, a trader could sell both contracts for, say, $1.05 and then pay off the winning contract $1 and keep the difference).

Both of these contracts have traded at much lower prices in the past, when other candidates (e.g., Hillary Clinton) were more likely to be elected President.  There are many other contracts traded and many ways to make use of them.  For example, there are contracts on how each state in the country will vote (recall that the US Presidential election is determined by the outcomes in the individual states, with the winner of each state election receiving the number of electors from that state; see here and here for more).  One site (see here) uses the Intrade prices from each state contract to predict the electoral college (see here for a lengthy pdf that describes the history of the electoral college and several criticisms).

Needless to say

, speculators in political futures markets are not perfect.  During the 2004 election

, exit poll data (that is the results of surveys of people who voted on election day) revealed that John Kerry was doing much better than expected.  The political futures markets reacted sharply and the price of the Kerry contracts rallied

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, before the actual data showed that George Bush would win the election (see here for a nice write-up).

This entry was posted on Friday, August 22nd, 2008 at 12:24 pm and is filed under Markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.