In Paul Krugman’-s blog entry, Done, at 4:39pm (EDT) on March 21, 2010, he commented: “-OK, nothing is sure in this world. Intrade is still giving Obamacare a 2.2% chance of failing, …”-
He was talking about the InTrade market on Health Care Reform. In theory, the market price in such a derivative market should equal the expectation of the underlying event coming true. However, Paul Krugman (and many others) forgot one of the most basic assumptions of the market model! Transaction costs.
When the market price is over 95, InTrade charges a transaction fee of 3 cents per contract (real money). While market prices are quoted in percentages, the payoff for a winning ticket is $10 (real money). Therefore, the transaction fee is 0.3% of the winning payoff. In addition, InTrade charges 10 cents per contract on expiry (if you “-win”-). That’-s another 1.0%.
So, when the market was quoting 97.8% likelihood of the HCR bill passing before June 2010, this didn’-t really mean that there was a 2.2% chance of the bill not passing. A winning ticket would be subject to 1.3% transaction fees. The real likelihood of failure was 0.9% –- approximating the uncertainty that Obama would be “-hit by a bus”- before signing the bill into law.
No rational investor would wish to purchase a share for more than 98.7, given the transaction costs. In a sense, this is the market’-s “-100%”-. Interestingly, at 1:49pm GMT today (March 23), there are 695 bids at 99.1 and 413 asks at 99.2. Clearly, some traders are not subject to the full transaction fees at InTrade. More about that here.
Why political futures markets got the health care bill so wrong.
By Daniel Gross
Posted Monday, March 22, 2010, at 6:05 PM ET
It would be very difficult to tote up all the times pundits pronounced the health care bill dead, and the prospects for the Obama administration dire—especially after the election of Scott Brown in January. Intrade, the political futures market, which functions as a conventional-wisdom-processing machine, also got health care wrong. Check out this chart for the contract on health care reform being passed by June 2010. The contract is worth 100 if it is passed, zero if it is not. After Brown’-s election, it slumped to as low as 20. As recently as March 17, it was below 40. Even as late as Friday, it was trading in the mid-80s. These trading data show that “-investors”- in this market were skeptical of the Obama administration’-s ability to pass significant health care legislation, right up until the end.
Is there a larger lesson here? (Aside from the obvious one, which is political futures markets usually aren’-t very good at predicting what actually will happen in the future?) I think so. And it’-s this: Don’-t short Obama. In fact, that’-s been the lesson of Obama’-s entire career so far.
[Stock market stuff inserted here.]
On some level, it’-s tough to blame the Intrade crowd for getting Obama and health care wrong. The type of people who trade there, folks who think they’-re quite savvy about money, the market, and politics, are the same conventional wisdom hawkers who were so monumentally wrong before the financial crisis. If you’-ve tuned into CNBC or Fox Business Channel, or read the Wall Street Journal since January 2009, you would have been subject to a constant stream of money managers, pundits, talking heads, and policy wonks declaring that the U.S. economy is becoming a socialist hellhole that is hostile to business and investors. (If there were a way to short Fox Business Channel, I’-d do it in a hurry.)
The conventional wisdom market has not yet internalized the message that it’-s dangerous to your financial and professional health to short Obama. Judging by the debate in the House last night, by the talk on cable news shows this morning (full of talk about how this is going to kill Democrats in November), and by the chatter on the business networks this morning (full of talk about how the tax increases in the health care bill will destroy the markets and the economy), the shorts haven’-t learned anything.
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I agree with Dan Gross that prediction markets are a “-conventional-wisdom-processing machine”-. Prediction markets incorporate expectations (informed by facts and expertise) just like the mass media do.
Prediction markets can’-t look into the far away future.
In the ObamaCare case, prediction markets have just been summarizing objectively, dynamically and quantitatively (day in, day out) what the political media were reporting about the health care reform, and about the prospect of its passing in Congress and of its signing by the President.
It would be easy for a scientist to verify that —-by comparing archived media articles with the historical InTrade prices.
I’-m not sure if you should particularly care about the little 5 or 10 point hedges (usually to the pessimistic side) that I’-ve periodically been recommending around the Intrade contract on the chances of reform passing. Even if you staffed a whole room full of the smartest vote-counters, modelers and analysts and had them work 24/7 on trying to beat the Intrade contract, I’-m not sure if they could come up with anything sufficiently rigorous to provide them with a real advantage. (That doesn’-t necessarily mean the market is “-efficient”-, but we’-ll save that conversation for another day.) But for what it’-s worth, the Intrade contract, which is trading at 75 percent right now, now looks about right to me or perhaps even a hair pessimistic.
I am utterly convinced Intrade participates in its own markets. Every few hours some kind of API hits the bids on the GOP 2012 nomination contract when the bids sum to more 100. It will even short bids at 0.1, which is a money losing proposition when you figure the transaction cost alone of 0.3 (since the price is below 5). Also, the amount of margin required to short all of these bids is in the millions of dollars.
So the actor has to a) not care about the transaction fee and b) have limitless margin. Intrade fits the bill for both of these. a) they don’-t care about transaction fees because they are ultimately collecting them and b) if you only short when the bids are summed to over 100, it’-s essentially an arb.
The trader also tells me that, on the InTrade forums where those questions were asked many times, InTrade never denied that they trade on their own prediction markets.
[…] I asked John Delaney and his tech team when I was doing my due diligence on InTrade a couple of years ago in Dublin – about the firm’s own participation in making markets – and the potential to ‘manage’ prices in ways that were outside of the normal price discovery mechanism. I came away from that meeting not convinced at all that adequate checks and balances were in place to protect against manipulation. […]
Details, details.
I am calling all my Deep Throats. Contact me. Tell me more.
