15 May 2008

Prediction markets aren't perfect

As of right now, intrade.com reports a 7.4 percent probability that Hillary Clinton will get the Democratic nomination for President -- and an 8.0 percent probability that she will be the next President.

That seems a bit unlikely to me.

Intrade isn't an efficient market; there are tons of arbitrage opportunities like this. (Some are more subtle.)

Although if you want to get technical, buying Clinton getting the Democratic nomination (at 74 cents for a contract that pays $10) and selling Clinton winning the '08 election (at 80 cents) isn't quite risk-free -- there's a nonzero chance that she might want so badly to be President that she'd run as an independent in order to do so. And it's my understanding that short selling (which would be necessary to pull this off) isn't possible on Intrade anyway.

2 comments:

John said...

It was worse earlier in the year.

If you look at John McCain's chart, you'll notice a stretch of time after he'd become the "presumptive" Republican nominee when he was trading around a 25% chance of eventual victory. Conventional wisdom gave him a slightly less than 50% chance of victory against Obama and perhaps a small advantage over Clinton.

That kind of sloth is supposed to tempt arbitrageurs into participation, but it's not happening here -- probably because smart money sees the institution as brittle. More liquidity would help, but the market has a negative overall epxtected return -- they keep the float on all bets.

I think Robin Hanson has a paper up somewhere at GMU on the rationality of predictions in unideal cases, and I doublethink his conclusion was that prediction markets approach an
ideal of rationality in the limit of many participants and degrade gracefully.

mja said...

Pretty sure Intrade has no restrictions on short selling, but don't forget commissions at $0.05/contract each way -- even if you hold to maturity they hit you with settlement fees. Also as John points out there is the question of float, if you try to sell the Clinton-to-be-president contract your $9.20 (margin required to cover worst case loss, which I think is how Intrade does it) is tied up earning no interest until the election, whereas the Democratic nominee contract presumably settles earlier.