Prediction markets and politics


Prediction markets allow speculators to buy or sell futures contracts related to future events. This sort of market has existed for agricultural and other commodities, such as corn or soybeans, for a long time. Those markets are a major part of the mechanism that determines the price you pay for food in the grocery store.

In traditional futures markets speculators are making a judgment about the price of some commodity at a given point in the future. For example, a commodity exchange might have futures contracts for corn. Suppose contracts for May corn are trading at $3.00 per bushel. If you think that the price of corn in May will be less than $3.00, then you want to enter into a contract to sell corn. You will get $3.00 per bushel, but if you are correct about the actual price at the time (suppose the price turns out to be only $2.50) you will fulfill that contract with corn you buy at a cheaper price and make a profit. Note traders almost never actually deliver or take delivery of the corn, you settle the trade with an offsetting contract.

So, what does that have to do with politics? Well…

In more recent years, future markets have developed that allow people to buy or sell futures contracts related to events, rather than commodities. These futures markets are called prediction markets. One of the earliest (maybe the first, I’m not sure) are the Iowa Electronic Markets, which is run by the B-School at the University of Iowa.

More recently, commercially run markets, such as Intrade, have sprung up. At Intrade you can trade on predictions related to the weather, the Academy Awards, various elections and other political events, and more. Let’s look at a potential trade in a US Senate race.

There is a contract at Intrade denominated as IN.SENATE2010.DEM. This contract settles at 100 if the Democratic candidate wins the Indiana US Senate seat in the 2010 election. It settles at 0 if the Democratic candidate doesn’t win. Each point on the contract is worth $0.10. So the contract is worth $10. If you look at the page for this contract, you’ll see that the contract is currently trading for around 25. (It might change by the time you read this.)

If I think that the Democratic candidate is going to win, then I can buy this contract for 25 ($2.50). If I am correct, then I will receive $10 making a $7.50 profit; if I am wrong I get nothing and lose my $2.50.

Who sells the contract? Who did I buy it from? Good question. I will buy it from some other speculator who has either submitted information indicating he is willing to sell at that price or one who responds to my input that I am willing to buy. The Intrade exchange is merely a broker and collects a commission on the contract. The person who sells my contract keeps my $2.50 if the Democratic candidate does not win. He pays me $10 (thus losing $7.50) if the Democratic candidate does win.

Now, I don’t plan on speculating on any elections. But these markets provide information about possible electoral outcomes. These contract prices can be interpreted as probabilities. The contract price of 25 for this contract implies that there is a 25% probability that the Dem candidate wins. At least that is the collective wisdom of people willing to put their money where their mouth is.

These prices change in response to events. Look at a chart of the closing price for this contract over the past month:

That’s kind of hard to read, but if you click through a couple of times, you can see a larger version. What this chart shows is that up until mid-February speculators figured that there was a 60-70% chance that the Democratic candidate would win this race. Something happened around Feb 15 to change their estimate; the probability of the Democratic candidate winning dropped quickly. Why might that be? Oh, yeah. Evan Bayh, the incumbent, dropped out of the race. This market accounted for that information and adjusted.

In an upcoming podcast, we will be discussing the fall election with respect to the Senate races. I’m using the information from the Intrade markets to prepare a macro simulation of the senatorial races. I’ll make a projection of how many seats the GOP may gain and will compare that to more traditional projections from other sources such as CQ Politics.

-chiptaylor

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One Response

  1. […] you are wondering what this has to do with politics, check out this great blog post by Chip Taylor on the Dark Horse Dispatch.  Just as markets exist for basketball games and horses, […]

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