Bayh

Writing recently in Slate, John Dickerson argues:

"The most likely beneficiary of Warner's departure may be Bayh, who was competing for a similar sphere of donors and activists as a representative of the centrist wing of the Democratic Party. As a former governor of Indiana, Bayh can claim executive experience, just as Warner could, and offer the same hope that as a favorite son he could turn a red state into one the Democrats could count on."

As I noted yesterday, the initial market response to the Warner withdrawal was that Edwards would be the main beneficiary. But there's also some support for Dickerson's view. At around the same time as the price of the Warner contract was collapsing, the price of the Bayh contract jumped upwards:



Still, the rise in price here is small compared to the rise in the Edwards contract, and even the Clinton contract has gone up by more. It'll be interesting to see what happens over the next few days.

Warner

At some point this morning it became clear the Mark Warner would not be seeking the Democratic presidential nomination for 2008. I'm not sure exactly when the first public announcement appeared, but here's a Reuters post stamped 9:55 AM.

As you might expect, the price of the Warner contract on Intrade (which would have paid $10.00 if he had been the nominee) collapsed rapidly from $1.50 to practically zero:

The price at 9:40 was $1.50; by 10:41 it was 11 cents. What's interesting about this is that the decline in price should have been matched by comparable increases in the prices of other contracts. Specifically, if the market believed that there was a 15% chance of a Warner nomination prior to the withdrawal, this probability should have been reallocated to other contenders once the announcement became public. This did not begin to happen for quite some time, and the process is still incomplete. The only contract to have risen significantly at this point is that for Edwards:

A sharp increase in price, from $0.81 to $1.28, took place during a ten minute interval starting at 11:33, about an hour after the collapse of the Warner contract. A couple of other contracts (Clinton, Bayh and Obama) have also seen modest increases but the main beneficiary of Warner's withdrawal seems to be Edwards.

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.

Arbitrage in Prediction Markets

One of the interesting things about the IEM Congessional Control Markets is that there are lots of different ways in which to take a position on an event. So, for example, if you want to bet on the event that Democrats take control of the House, there are four ways to do it: (i) buy RH.lose06 in the House06 market, (ii) buy a fixed price bundle and then sell both RH.gain06 and RH.hold06 in the House06 market, (iii) buy both NH_RS06 and NH_NS06 in the Congress06 market, or (iv) buy a fixed price bundle and then sell both RH_RS06 and RH_NS06 in the Congress06 market. In a thick market with heavy trading and optimal behavior on the part of traders, these four different ways of entering the same position should cost the same. But these are thin markets with varying degrees of sophistication among participants, so prices across contracts and markets are sometimes not mutually consistent.

In fact, sometimes prices get so misaligned that there appears an opportunity for aribrtage: one can take a combination of positions that yields a sure profit (regardless of what happens in the election). Consider for instance the prices as of 7:30 CST this morning:

07:30:00 CST, Thursday, October 05, 2006.

Symbol	Bid	Ask	Last
RH_RS06	0.445	0.460	0.430
RH_NS06	0.031	0.045	0.031
NH_RS06	0.300	0.315	0.320
NH_NS06	0.208	0.235	0.207

Symbol	Bid	Ask	Last
RH.gain06	0.022	0.039	0.022
RH.hold06	0.516	0.534	0.520
RH.lose06	0.455	0.515	0.462

At these prices, a trader could bet on Republican loss of the house in the House06 market and simultaneously bet on Republicans maintaining control of the house in Congress06 for a sure profit. Selling RH.gain06 and RH.hold06 in the House06 market, and selling NH_RS06 and NH_NS06 in the Congress market has a total net cost of $0.954 per contract. Whathever happens on November 7, the positions in one market will expire at $1 while positions in the other will expire worthless. So you're buying $1 for a $0.954 on each set of contracts traded in this way.

Nobody is going to get rich looking for opportunities such as this, which is why it's so easy to find them. But this example is a nice way to see the logic underlying arbitrage based pricing relationships such as the put-call parity theorem.

Out of Hibernation

I think it's time to revive this blog after almost three years of hibernation. With the elections fast approaching, there's a lot of interesting activity on the prediction markets. I've been looking at Intrade and the Iowa Electronic Markets (Intrade is the same exchange as Tradesports, about which I've posted before).

What interests me about these markets is the manner in which their design affects the accuracy of their predictions. The prices in one market can be inconsistent with those in another market, sometimes even on the same exchange. This sets up opportunities for arbitrage, although the gains are typically pretty small. It also means that the markets sometimes make conflicting predictions, which raises the question of which market is more accurate on average. This is where market design and participation matter.

So what's been going on recently? Well, Intrade's SENATE.GOP.2006 contract (which pays if Republicans end up with 50 or more seats) has fallen from above 80 to around 75, which means that the Dems have about a one-in-four chance of taking the senate. The decline seems to be driven by Harold Ford's momentum in Tennessee: the TN.SENATE06.DEM contact now gives Ford an even chance of winning.

Meanwhile, thanks perhaps to this, the HOUSE.GOP.2006 contract (which pays if Republicans maintain control) has tumbled too, and now gives the Dems a slightly better than even chance of taking the House.