December 22, 2003

Policy Markets

Daniel Davies rants about how the tradesports.com policy markets are inefficient:

Crooked Timber: Actually Existing Terrorism Futures : I'd also point out that if any CT readers fancy having a punt that the threat will stay Orange for the remaining nine months of the year, they certainly should not buy Orange at 88; selling Red at 5 and Yellow at 10 gives you a better profit if Orange persists, plus a free bet on Blue and Green. It doesn't say wonders about the efficiency or liquidty of the market that it has glaring anomalies in it like that (it's also possible to bet on the Lord of the Rings film taking more than $116m over the weekend, which it did, and you can also have a look at a US Economic numbers book in which the probability of the Personal Incomes number being above 0.4% is quoted at 55-65, while the probability of it being above 0.7% is quoted 61-70. (Update: Or at least it was before I took out some sucker's bid; if you want to fact-check my ass, email me and I'll send you the screenshot).

But he cannot resist trying to profit from the inefficiency--and so pushes prices to their rational, efficient values.

Posted by DeLong at December 22, 2003 09:46 AM | TrackBack

Comments

That's not actually true; the implied probabilities on the National Security contract and the Personal Incomes contract still don't make sense, but I can't push them any further without taking on market risk ...

Posted by: dsquared on December 22, 2003 10:14 AM

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Brad -
As a prominate liberal ecconomist who supports these betting markets, do you know of studies you can cite or link to that evaluate, either way, their effectiveness? In his post, dsquared takes a mocking tone with regard to the empirical evidence, but every statisical study I have read seems to support the markets, and I do not have any idea what he is talking about. Is their ANY reason to share his skepticism based on empirical evidence?

Posted by: Decnavda on December 22, 2003 12:18 PM

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What are the odds the Yuan gets floated before the 2004 election?

Posted by: Michael Carroll on December 22, 2003 01:49 PM

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John Quiggin linked to an assessment in the Australian context which is the only serious study I've seen on the issue. It's on his blog and on CT.

Posted by: dsquared on December 22, 2003 01:50 PM

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Arbitrage is a harsh mistress.

Posted by: J. Michael Neal on December 22, 2003 03:43 PM

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If DD wants to make money from mispriced bets he should keep quiet - telling everyone just ensures that the opportunity is quickly arbitraged away.

The horse-racing industry has a wise saying about inside tips - "those who know don't say, and those who say don't know".

Posted by: derrida derider on December 22, 2003 03:47 PM

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If DD wants to make money from mispriced bets he should keep quiet - telling everyone just ensures that the opportunity is quickly arbitraged away.

The horse-racing industry has a wise saying about inside tips - "those who know don't say, and those who say don't know".

Posted by: derrida derider on December 22, 2003 03:48 PM

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The way I see it, he's holding election markets like the Iowa Electronic Markets up to an unreasonable standard: that of being better in principle than anything like a simple mathematical function of the aggregate poll data. Maybe we could do better with some function of poll numbers, but I haven't seen any good analysis of what that function is.

I have no opinion about the Tradesports threat-level market, but I think of the IEM as basically an improvement on asking a bunch of political opinion columnists and bloggers what they think is going to happen. It's just like that, except that the people betting have some incentive to weight their guesses by degree of certainty and pool the results, which probably improves the situation.

There have been times when I wondered what they were smoking, such as the IEM's months-long insistence that Hillary Clinton had a chance of getting the nomination significantly different from nil, or the way that Howard Dean turned into the only candidate considerably less electable than Bush the moment that Gore endorsed him. I think their traders might skew Republican.

Posted by: Matt McIrvin on December 22, 2003 04:18 PM

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I don't know what qualifies as "serious," but Forsythe, Nelson, et.al.'s piece in the American Economic Review in December 1992 seems serious to me. So too does Berg and Forsythe's "Results from a Dozen Years of Election Futures Markets Research."

As for the Wolfers study, available here: http://faculty-gsb.stanford.edu/wolfers/Papers/AJPS%20Three%20Tools%20Article.pdf, it shows that bettors called 43 of 47 regional races correctly, in the almost complete absence of specific polls. (There were polls in three of the races.) Now, I'm not Australian, so I have no idea if regional races are all gimmes, but Wolfers says the list of 47 included "most marginal seats" and a number of "tight races." That performance is at the very least interesting, considering that Quiggin writes that the real issue is "how betting markets would perform in the absence of polls."

Matt, IEM's traders do skew Republican, or at least historically they always have.

Posted by: James Surowiecki on December 22, 2003 04:49 PM

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I don't know what qualifies as "serious," but Forsythe, Nelson, et.al.'s piece in the American Economic Review in December 1992 seems serious to me. So too does Berg and Forsythe's "Results from a Dozen Years of Election Futures Markets Research."

As for the Wolfers study, available here: http://faculty-gsb.stanford.edu/wolfers/Papers/AJPS%20Three%20Tools%20Article.pdf, it shows that bettors called 43 of 47 regional races correctly, in the almost complete absence of specific polls. (There were polls in three of the races.) Now, I'm not Australian, so I have no idea if regional races are all gimmes, but Wolfers says the list of 47 included "most marginal seats" and a number of "tight races." That performance is at the very least interesting, considering that Quiggin writes that the real issue is "how betting markets would perform in the absence of polls."

Matt, IEM's traders do skew Republican, or at least historically they always have.

Posted by: James Surowiecki on December 22, 2003 04:54 PM

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Didn't anyone notice that the government raised the threat level to Orange today, said it was the clearest threat since 9/11, and we face an imminent attack on the level of 9/11, etc... AND THE STOCK MARKET WENT UP?

WTF? Does Wall Street feel that the Bush administration has so politicized national security that they have zero credibility when they announce terrorist threats?

Posted by: Dave Johnson on December 22, 2003 09:31 PM

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Dave: it's not at all impossible that Wall Street, which is a proper market, not a toy one, anticipated the announcement and had already priced it in.

If DD wants to make money from mispriced bets he should keep quiet - telling everyone just ensures that the opportunity is quickly arbitraged away.

To be honest, I just put the trade on because I was trying to make sure I understood how Tradesports works; I think I'm gonna make like $3.50. For those kind of arbitrages, I'd rather have the bragging rights than the money.

Posted by: dsquared on December 22, 2003 11:20 PM

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This thread appears to have ground to a halt before it even started, but if anyone is reading, I wanted to raise a more theoretical question connected to Brad's short comment about Daniel's post, namely "he cannot resist trying to profit from the inefficiency -- and so pushes prices to their rational, efficient values."

The inefficiency that Daniel took advantage of here was a literal one, which is to say that the Tradesports' forecasts of the probability of events (in this case, alert levels) were internally inconsistent. If the chance of the alert level staying Orange for the rest of the year are 88, the chance of there being a Red, Yellow, Blue, or Green alert at sometime in the next nine days (I think it should be days, and that "nine months" is a typo) should not add up to more than 12, which it does. So essentially the market is giving Daniel free money, and as a good arb he's taking it. (This probably reflects, in addition to other potential problems, the fact that most speculative markets, especially when there's not much money at stake, tend to overprice longshots.)

Now, Daniel's investment therefore pushes prices toward their "rational, efficient" value in a specific sense: it makes the market's forecasts more internally consistent. My problem is this: There is a profound difference between someone investing to make a market rational and efficient in this sense -- that is, saying to the market: "You say X has A% chance of happening, which means that Y must have B% chance of happening, but Y's price means it has C% chance of happening. Fix it." -- and someone investing to make a market rational and efficient in the sense that its subjective probabilities in fact reflect objective probabilities.

To believe that someone can be an arb in the first case, all we need to believe, literally, is that he can add. But to believe that someone can be an arb in the second case, we need to believe that he has systematically better insights into objective probabilities (that is, of events in the world happening) than the market as a whole does. (Not better than those of individual investors, which would not surprise me, but better than the market, in which investors' random forecasting errors will have cancelled themselves out). This seems highly unlikely even in a single security. It seems impossible across the range of securities that are traded in any market.

But there's another problem. If the market is "irrational" in the second sense (that is, it's not internally inconsistent but it is systematically over- or underestimating objective probabilities), and the intelligent arb, the shark, comes along to push it back toward rationality, why does the market not just go right back to being irrational once the arb has made his trade? Steve Ross does not have enough capital to outweigh all the other investors in an asset, so how can his rationality possibly offset their irrationality (assuming for argument's sake that they are irrational)?

The implicit assumption behind the idea that arbs (in the second sense) are what keep market prices rational seems to be that once the arbs act, all the other previously irrational investors suddenly snap to and realize that they should stop being so foolish. But there is no reason, theoretical or empirical or experimental, to believe that this is the case. If a large group of investors is irrational, having someone come along and make a trade that implies they're wrong is not suddenly going to make them change their mind. They'll just go back to being irrational once his capital is exhausted.

Now, the obvious argument is that the arb will make money from his trade and the irrational people will lose from theirs, and over time that will have the desired effect. But why should we think this is the case? Even if you set aside Brad's 1991 argument about the ability of noise traders to make money while pushing prices away from rationality, the only way an arb can make money is if prices eventually become rational. Intrinsic value is 100, asset is at 140, arb sells it short and cleans up when it returns to 100. But how does the price get to 100? If it's solely because of the arb's short-selling, then the arb isn't making any money. (If the price is at 140, I go in to start selling short, and the added supply immediately sends the price to 100, I'm not making much money.) The only way for the arb to prosper is if the market, independent of his intervention, moves toward rationality. But if the market, in the absence of the sharks, is irrational, then why would we believe that it ever would move toward rationality?

Now, in cases where markets are finite and payoffs are market-independent -- as with, say, sports betting -- the arb can make money just by being right, regardless of whether the market price moves toward rationality or not. But that has no impact, in the interim, on whether the market becomes more rational or not, since the irrational investors won't lose their money until the market's end. (In other words, over the course of the market, the arb isn't getting richer as the irrational investors are getting poorer, unless the market, independent of the arb, is becoming more rational.)

The shark theory of efficient markets conflates two conceptions of arbitrage (not literally, but metaphorically) and assumes that since arbs can and do make internally irrational markets more rational, they must also be able to make (and are making) what you might call externally or objectively irrational markets more rational. But the second does not follow from the first.

In the unlikely event that anyone's still reading, I should say that this doesn't mean that I think markets are always irrational. Far from it. I just don't think that market rationality is the result of a few keen-eyed wolves keeping all the ignorant sheep in line.

Posted by: James Surowiecki on December 23, 2003 06:54 AM

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Talk about demonizing Democrats! This amusing typo from the Iowa Electronic Markets Propectus for the 2004 US PRESIDENTIAL VOTE SHARE MARKET:

"After the Demoncratic National Convention is completed and its official nominee determined, all contracts not related to that nominee will be declared worthless and expire."

Freudian slip?


Posted by: Kosh on December 23, 2003 07:36 AM

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"Dave: it's not at all impossible that Wall Street, which is a proper market, not a toy one, anticipated the announcement and had already priced it in."

It's up more than 300 points this month.

Posted by: Dave Johnson on December 23, 2003 07:40 AM

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James,

It seems to me that when you write of "the market" you are thinking that there is some huge liner that has to be turned around. You seem to forget that the shark only has to change the margin, and the huge volume of the intramargin has to follow the reset.

Put differently, once a shark has made the single trade of covering his short, the rest of the market have to find somebody grossly "irrational" to get the margin back to where it had been before the ahark took its bite.

Posted by: David Lloyd-Jones on December 23, 2003 07:55 AM

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David --

I don't believe that changing the price on the "margin" changes the price for all investors unless they all consent to the change. Let's say I own 10,000 shares of a stock, which I -- like the market -- believe is fairly valued. The shark, who thinks the stock is woefully undervalued, comes in and takes a bite by buying 10,000 shares, raising the price by A%. The stock is now overvalued by A% in my mind, and if I'm rational (that is, rational in my irrational undervaluation of the stock) I will sell my 10,000 shares and immediately send the price back where it was before the shark bit.

If I do not sell, my not selling is setting the new price as much as the shark's buying did, because it's only my decision (and that of all the other shareholders) to "not sell" that keeps the price at its new level.

Of course, someone is always setting the price on the margin in a purely functional sense, but unless they have enough capital to outweigh the buying (or selling) power of all other investors, they cannot, in any sense, determine the price of the asset. There are no intra-marginal investors in an asset (aside from those who are legally prohibited from selling), because at every moment (not literally, but effectively) an investor is deciding whether to sell or not-sell the assets he owns, and those decisions are as determinative of the price of the asset as any others.

Posted by: James Surowiecki on December 23, 2003 09:50 AM

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David --

I don't believe that changing the price on the "margin" changes the price for all investors unless they all consent to the change. Let's say I own 10,000 shares of a stock, which I -- like the market -- believe is fairly valued. The shark, who thinks the stock is woefully undervalued, comes in and takes a bite by buying 10,000 shares, raising the price by A%. The stock is now overvalued by A% in my mind, and if I'm rational (that is, rational in my irrational undervaluation of the stock) I will sell my 10,000 shares and immediately send the price back where it was before the shark bit.

If I do not sell, my not selling is setting the new price as much as the shark's buying did, because it's only my decision (and that of all the other shareholders) to "not sell" that keeps the price at its new level.

Of course, someone is always setting the price on the margin in a purely functional sense, but unless they have enough capital to outweigh the buying (or selling) power of all other investors, they cannot, in any sense, determine the price of the asset. There are no intra-marginal investors in an asset (aside from those who are legally prohibited from selling), because at every moment (not literally, but effectively) an investor is deciding whether to sell or not-sell the assets he owns, and those decisions are as determinative of the price of the asset as any others.

Posted by: James Surowiecki on December 23, 2003 09:55 AM

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I was looking at some of Brad's earlier work on "noise trading" in financial markets. How would someone trading on the "momentum" of a particular candidate's shares influence policy markets? Would this potentially diminish the policy markets predictive value? Or in the case of predicting election outcomes, could "momentum" be a tangible factor?

Posted by: Kosh on December 23, 2003 02:39 PM

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