Thursday, August 10, 2006

A Predictions Markets Mess

The prediction market exchange Tradesports have themselves a little controversy over North Korean missiles.

I have written about prediction (or information markets) before. Consider some future binary event like whether Hillary Clinton will be the democratic nominee for president in 2006. One can create a security 2008DEM.NOM.CLINTON that pays off $100 if Clinton wins the nomination and $0 if she doesn't. Then allow trading on the security including selling short. The price of the security will correspond to the probability that the event will occur, and studies have shown that these probabilities predict better, in general, than experts and polls. Tradesports has such a security on Clinton and the price as I write this for 2008DEM.NOM.CLINTON is 41.9 indicating Clinton has a 41.9% chance of winning the nomination.

Tradesports had another security N.KOREA.MISSILE.31JUL that would pay off if North Korea launces a test missle that leaves North Korean air space by July 31. As you might remember, North Korea did fire test missles on the fourth of July. So it seems like the security N.KOREA.MISSILE.31JUL should have paid off at $100.

Here's the rub. The fine details of the contract required that the US Department of Defense verify that the missiles left North Korean air space. Tradesports couldn't get the verification so they expired the security at $0.

Those who predicted the North Korean missile launch lost real money on a technicality which risks the accuracy of these markets. They no longer predict whether a launch occurs, just whether the DoD would acknowledge it.

More from Smart Money, the Freakonomics Blog and full details and opinions by Chris Masse.

3 comments:

  1. Chris. F. Masse .COM11:46 AM, August 10, 2006

    Hello professor Lance Fortnow,

    The intent and the letter of the contract should always coincide, no matter what.

    In the "current news" prediction markets, TradeSports felt obligated to cite the name of the source of information for expiry, so as to kill any dispute in the egg.

    The contrary has happened. Naming in advance *the* source for expiry is *the* source of the problem here.

    TradeSports is a bet settlement judge. You are a good judge if you are educated, open minded, and curious. A judge should be free to use whatever source of information he/she sees fit.

    Happy week,

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  2. I have run into bigger problems with these futures contracts. Last year, I had the idea that I could look for arbitrage by wagering at different "prediction markets" (aka, casinos.)

    I found a case last year where I could bet on Karl Rove's indictment (at Tradesports) and bet against Karl Rove's indictment (at Sportsbook) and still make money, in theory.

    The catch is the wording of the wager at differed between the two sites. The wording at Sportsbook was "Will Karl Rove Resign or Be Fired" and they had a "grading date" (aka judgement day) of 11/15/05. So, based on the proposition, I thought it was a safe bet because I figured Bush and Rove are so arrogant, Rove wouldn't resign or be fired even if Fitzgerald indicted him.

    You can guess what happened: 11/15/05 came and went, Rove hadn't been indicted (and certainly hadn't resigned or been fired) and Sportsbook refused to pay because he was "still under investigation." So even though the wording of the wager doesn't even mention Fitz's possible indictment, they changed the rules. Finally, they settled when Rove's lawyer indicated that Fitzgerald signaled no charges would be fired against Rove.

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  3. This conundrum is the question motivating the development of information currency. Financial markets for derivative instruments with information as the underlying will make it possible to create a new type of all-source analysis system... but that's not what you will find at http://infoeng.sf.net quite yet. :)
    Thanks for the post!

    ReplyDelete