Wednesday, January 06, 2010

On Inference and Coordination in Speculative Markets

In my previous post I argued that the incentive to manipulate prices in prediction markets is strongest when there is a positive feedback between subjective beliefs and objective probabilities. In response, Robin Hanson made the following observation:
The possibility of self-fulfilling or self-defeating prophecies is an issue with any forecasting mechanism where forecasters have any incentives to offer more, vs. less, accurate forecasts. It is not a problem particular to prediction markets.
This is certainly true but (as I said in my reply) the anonymity of participation in prediction markets means that in interpreting the data, we cannot discount the forecasts of those who have the greatest incentives to mislead us. Traders who try to manipulate beliefs will typically lose money, while pollsters and academics who do so will lose reputation and credibility. This is why polling done on behalf of political parties is often discounted and excluded from aggregates, and why house effects play such an important role in the interpretation of polling data.
On the other hand, if attempts at manipulation in prediction markets are too blatant, they can result in strong and rapid push back by other traders. In fact, the possibility of manipulation increases market participation and liquidity because it generates a profit opportunity for those who can quickly detect and exploit it. But how might manipulation be detected in practice?
Put yourself in the position of a trader who notices a significant, unexplained rise in the price of a contract. How should such a movement be interpreted? It could reflect some new information that has not yet filtered into the public sphere, in which case it might be profitable to buy ahead of the news. On the other hand, it might reflect an attempt at price manipulation (or simply irrational exuberance) on the part of some individuals, in which case it might be profitable to sell short before the price returns to more reasonable levels.
In reacting to such price movements, therefore, traders face an inference problem. Identifying the cause of the change in price is important in predicting the direction of subsequent movements, and hence in selecting the positions to enter. But even if one is fairly confident about the cause, trading on the opportunity carries risks unless it is done in concert with others. A single trader will typically not be able to arrest movements in price even if these are shifts away from fundamentals. One could enter a position and wait, but this could tie up margin and result in lost opportunities elsewhere. Even worse, if the waiting period is long, a shift in fundamentals could occur that reverses the expected value of one's position. This gives rise to a coordination problem: traders could all diminish the risk they face if they act against market manipulation in unison.
Both the inference problem and the coordination problem can be solved by effective communication, and there are several examples on the Intrade forum of traders trying to make sense of price movements and coordinate a collective response. One such incident pertains to a suspicious movement in the price of the contract for Bill Richardson in the democratic vice-presidential nominee market on February 28, 2008.
At the start of the day, and for several days previously, the price of this contract was around 6. (The price is expressed as a percentage of the $10 contract face value, so each contract was selling for around 60 cents.) In the late afternoon, the price suddenly doubled, and kept rising until it reached 20 before falling back down to single digits in a matter of hours. A trader spotted the initial jump in price, and began a thread on the forum that is quite revealing about the manner in which the inference and coordination problems are sometimes tackled. Let's pick up the thread at around 5pm, when "speedo" notices a sharp, unexplained rise in price:
28/02/2008 17:01:31
richardson.vp just doubled, there is a standing offer to buy 128 at 12. any idea why?
28/02/2008 18:16:52
I can't find any news that would drive up the Richardson VP contract this much (last trade at 15, high bid at 13.2).
28/02/2008 19:30:36
now its trading at 18 - cant see anything either
28/02/2008 19:44:07
Could it be that someone heard a rumor richardson was set to endorse, and is planning to get a small bump from that, then get out?

I really can't find any rumors even online of anything happening today. Seems like only 1-2 people are propping this contract up.
28/02/2008 19:52:01
Yes - seems like is about to endorse one of the candidates.

I assume there can be no doubt that it will be Obama? But would that be enough to earn him a spot?
28/02/2008 19:56:36
That news has been out there for a while. So it wouldnt really justify such a big bump.
28/02/2008 21:12:46
I can't see anything either. I've gone ahead and sold some at 18.
28/02/2008 21:37:03
It's up to 20 now, but unfortunately I'm out of margin.
28/02/2008 21:50:58
I'm out of margin too ... I really can't figure this one out. The person who is doing this seems to have taken out a $1-$2k bet on Richardson...
About an hour and half later, the price falls back to a high bid of 11 and keeps sliding:
28/02/2008 22:10:21
Now there are some big orders on the buy side at 11 and 8. The guy buying it up seems to have run out of steam...
28/02/2008 22:13:00
He STONGLY hinted last week on Wolf Blitzer that he would endorse Obama. He has a snowball's chance in hell of getting the VP spot though...
28/02/2008 22:20:02
Yes, he's out of steam, thanks to you, me, and whoever else jumped at the opportunity. We should be able to cover these shorts pretty soon. This is a good thread.
29/02/2008 00:22:02
... Wish I read this thread a couple of hours ago as shorting Richardson @ 18 is TREMENDOUS VALUE.
From now on, I will check this section of the political thread first.
This example suggests to me that if the Intrade forum did not exist, market manipulation would be easier and less costly.
The inference and coordination problems are not confined to prediction markets: they arise in speculative markets more generally. A central finding in a 2003 Econometrica paper by Abreu and Brunnermeier is that even if traders are perfectly able to solve the inference problem, their inability to coordinate their actions can give rise to bubbles and crashes. I consider this to be a robust insight, and have discussed it at some length in an earlier post on market efficiency.


Update (1/7): Brad DeLong has an interesting post on the efficient markets hypothesis, with links to recent pieces by Justin Fox and Paul Kedrosky. One of the many unfortunate consequences of the EMH is that it inhibits serious research into the process through which information (and disinformation) comes to be reflected in prices.


Update (1/9). Robin Hanson's reply to DeLong and Kedrosky is worth reading. I think he's right to point out that Monday morning quarterbacking is too easy, but disagree with his claim that "to deny EMH is to assert that prices are predictably wrong." The EMH makes a stronger claim than price unpredictability; it identifies prices with fundamental values. For instance, unpredictability is consistent with excess volatility in the sense of Shiller (1981), but the EMH is not. Neverthless, if one is going to talk about the Federal Reserve identifying and reacting to bubbles in real time, it's important to settle the predictability question. 

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