Saturday, 5 May 2012

Playing the Prediction Markets



We have markets to trade thousands of stocks, bonds and derivatives, but Intrade is taking ‘market making’ to a whole new level. Intrade allows people to play the prediction markets, in which you buy or sell into hundreds of real world events. Instead of searching for a company’s intrinsic value, an investor in the prediction markets is simply finding the probability of an uncertain future events from occurring. Some examples of markets include Barack Obama being reelected or the Avengers grossing over $175M in its opening weekend. Markets are always defined on a yes or no basis, such that you buy shares of an event you believe is going to happen and sell otherwise. If the event does happen, then the market is settled at $10 and if it does not then it is settled at $0. The idea for this range being that a market price of $4 indicates a 40% probability of the event actually occurring.

The evolution of prediction markets brings the world of investing and trading to an entire different audience. While once only those knowledgeable in finance had the skills to accurately price a stock or option, now any avid American Idol watcher can bet on the next winner or any keen physicist can bet on the Higgs Boson particle being found before December 31, 2012. Further, if there are no markets of which you are familiar with, you can easily create one. However, the large problem with such an unregulated market is the even larger information asymmetry. While you may track all the news and research developments coming out of CERN and make your bet on the Higgs Boson, there’s nothing stopping an actual CERN scientist involved in the project on putting money on the same outcome- bringing insider trading to an entirely different level. Beyond that, since there are only 82,000 users in the Intrade platform, liquidity becomes a big issue and an individual may actually be able to move markets if they invest a moderate amount of money into an outcome. Whether there are controls in place for these kinds of behaviors is either unknown or very vaguely stated on the website, but regardless good things to think about before putting your savings on the probability of NASA announcing the discovery of extraterrestrial life by the end of the year. 

-Vivien Sung

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