Friday, October 06, 2006

Price Inconsistencies

In my last post I provided an example of price inconsistencies across contracts in the Iowa Electronic Markets. These discrepancies are usually pretty minor. But price inconsistencies across different exchanges can be quite large, which makes you wonder about the rationality of traders.

Here's a recent example. The IEM House06 market has two contracts (RH.hold06 and RH.gain06) which, taken together, are equivalent to the HOUSE.GOP.2006 contract on Intrade. In fact, IEM's RH.hold06 contract is dominated by Intrade's HOUSE.GOP.2006 contract, since the former expires at zero if the Republicans gain seats. So the price of RH.hold06 should never exceed that of HOUSE.GOP.2006.

But take a look at the prices of HOUSE.GOP.2006 on Intrade between 10/3 and 10/6:













At no point did it cost more that $4.90 for a contract that pays $10 if the Republicans keep the House. The average price was $4.52 on the 4th and $4.38 on the 5th, with almost $120,000 worth of contracts traded over those two days combined. Now take a look at the IEM prices on October 4 and 5:

Date
Contract
Units
$Volume
AvgPrice
10/04/06
RH.gain06
128
3.348
0.026
10/04/06
RH.hold06
275
140.369
0.510
10/05/06
RH.gain06
249
5.812
0.023
10/05/06
RH.hold06
673
336.133
0.499

To buy a set of contracts that are equivalent to HOUSE.GOP.2006 cost $5.36 on average on the 4th and $5.22 on the 5th. That's a price difference of more than 18%.

Why did traders on IEM pay so much more for contracts that they could have purchased on Intrade? I'm not really sure about this, but it's clear that the traders on these two markets are receiving different information, or processing it in different ways. Meanwhile, the stakes on IEM are too small to make it worthwhile for someone to engage in arbitrage across the two exchanges.

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