Financial news is dominated by a narrative of the various asset markets around the globe. Turn on CNBC and within seconds you be apprised of the current status of stocks trading on the New York Stock Exchange. Wait a little longer and you’ll find out how foreign stocks are doing. Besides these markets for assets, there are trading exchanges known as Prediction Markets that assign likelihoods to individual events. Here, we’ll focus on this comparatively new phenomenon.
Prediction markets, also known as idea futures, are created for the purpose of assigning value or likelihood to propositions. Assets are created whose final cash value is tied to a particular event (e.g., Will Hillary Clinton win the Democratic nomination?) or parameter (e.g., opening weekend box office sales for “Sex and the City”). The current market prices are interpreted as predictions of the probability of the event or the expected value of the parameter. Prediction markets are thus structured as betting exchanges, without any risk for the bookmaker. At first glance, the prediction market resembles the NASDAQ or a commodity futures market with common measures such as bid price, ask price, open interest, and trading volume. The information revealed by the prices is considered by many researchers to be an unbiased and reasonably accurate estimator of true probability. One of the most popular areas for contracts in prediction markets is politics. An academic prediction market sponsored by the University of Iowa has been handicapping the presidential race since 1988 with excellent results. Its average error in forecasting the popular vote is only 1.4%.
The Gallup poll has an average error of 2.0% over the same period. Prediction markets function well in generating voting outcomes even when there is no polling to serve as a guidepost. For example, Australian bookmakers offer markets on district level political races (without polling) and the resulting spreads have been quite accurate. The trading volume of prediction markets thus far is insufficient to make them realistic hedging tools for investors. However, there is escalating interest in a number of innovative prediction market contracts. Among the biggest prediction markets is Intrade which is located in the United Kingdom. There is a wide range of economic and political propositions that are tradable on its website. Intrade has a contract which allows investors to invest money on the likelihood that the US falls into recession in 2008.
Traded since August of 2007, the ongoing price seems to reflect new economic data with reasonable speed and efficiency. The chart below reveals that the market consensus for an American recession has ranged from a probability of about 75% to 25%. Notably the contract price began sinking in late April – just before preliminary GDP growth for the first quarter was released on April 30th. The statistical release revealed that the US economy was still growing in the first quarter – contrary to the consensus market sentiment. The recession “price” continued to fall as positive earnings and leading economic indicators became public. Along the political front, both Intrade and the Iowa Electronic Market made Obama the odds on favorite to capture the Democratic nomination just after Super Tuesday. In retrospect, the market called the eventual winner before the political pundit class. It is worth surveying some current prices for insight into the near future.
As this issue goes to press, Intrade futures assign a 40% likelihood to a John McCain presidency while Barack Obama has been assigned a 93% chance of securing the Democratic party’s nomination. Many companies are applying prediction market theory to corporate events such as new product offerings. Research has found that play money is about as effective as real money in achieving accurate outcomes. Google is a case in point. It uses prediction markets with employee participation to forecast product launch dates and to estimate product usage. Even if one is not inclined to gamble, it is still useful to observe the collective wisdom of a wide base of participants. Insightful market prices can be found on the internet and it is likely that both private and public prediction markets will continue to expand.