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Tuesday, November 07, 2006

Prediction Markets and Elections - Updated

I'm a big fan of prediction markets. They're a very good way of illustrating how markets impound information into prices.

Since today is election day, I thought I'd put a link up to Tradesports. For those of you who've never heard of it, Tradesports runs a futures market that allows you to bet on various events. Since the contract pays $1 if the event occurs, some fairly basic algebra shows that its fair price is essentially the probability that the event will occur.

To illustrate this, let's look at the contracts for Republican Control of the House and Senate. They're trading at $0.17 and $0.698 at the time of this posting. This implies that the traders in these markets currently assess the probability of Republicans retaining control of the House at 17% and of the Senate at 69.8%.

To see how information affects the contracts' prices, assume a trader had information that led him to believe that the chance of Republicans retaining House control was actually much higher than 17% (let's say 45%, for example). If so, he'd consider the current price a real bargain, and would start buying contracts. This would drive the price up until his information was fully reflected in the price.

Like I've said before, they're not a perfect predictor. But I do trust them much more than polls. I have several friends who make it a point to answer incorrectly whenever a pollster calls -- just so the polls will be less useful. Granted, I have a pretty contrarian bunch of friends, but I doubt they're alone.

In contract, in a prrediction market, the traders' own personal ideologies wouldn't matter - if they thought the probabilities were off, they'd trade in the contracts to make money.

Any one trader could be wrong. But if there are enough players in the market, the prices would be pretty good aggregators of everyone's info.

So check into Tradesports throughout the day, and see how the prices (and hence, the probabilities) change.

Updated 11/8: As of 10:15 a.m., Tradesports gave the Republicans between a 10.5% and 12.5% chance of retaining control in the Senate (obviously, trading in the House Control contract has closed).

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