How off is InTrade?

by on February 12, 2008 at 7:20 pm in Economics | Permalink

David Leonhardt weighs in.  The other day John Nye and I were discussing that de facto limits on the size of effective bets are the biggest problem hindering effective price discovery.  When you can become a millionaire on InTrade, that’s when its prices will become much better forecasters.  Nonetheless I agree with the piece’s conclusion:

If you have any better ideas of where to look, let me know.

But some inefficiencies need to be taken with a grain of salt:

Mr. Ravitch has made a nice profit betting against Ron Paul,
the libertarian who late last year was, amazingly, given almost a 10
percent chance of becoming the Republican nominee. “If you asked anyone
in politics whether there was ever, at any point, a 10 percent chance
of Ron Paul being the nominee,” Mr. Ravitch said, without finishing the
sentence. “That sort of makes my case for me.”

When it comes to the long shots, remember that InTrade takes deposits in non-interest-bearing cash rather than T-Bills.  In the meantime observers need to adjust their expectations accordingly and not interpret all the prices are pure percentages.  I recall Paul trading at about 7 or 8 percent.  Let’s say you shorted Paul last December.  You’re locking up your cash for quite a while at zero percent interest and when Paul fails you’re not going to net as much as you thought.  In other words, there is a partial short sale constraint on this market and its prices need to be understood accordingly.

Of course there is a reason why InTrade insists on earning the float and that directs our attention back to the zero-sum property of the bets.  That’s another reason why prediction markets probably won’t ever forecast as well as the stock market: their users have to be charged or taxed at a higher rate.  The expected rate of return in InTrade is negative; the expected rate of return in the stock market is seven percent minus commissions.  Where would you rather put your smarts to work?

Will Perkins February 12, 2008 at 8:01 pm

how about paying people for making predictions? (i.e. a dollar’s bet pays $1.03 or something; or perhaps prize money for top results of bettors). if the information was actually worth anything, it would be worthwhile to make predicting a positive-sum game for the participants.

Ted February 12, 2008 at 8:03 pm

Correction: the aggregate return for Intrade is negative. That doesn’t make the expected return negative. (Similarly: poker.) Ravitch is very conscious of the time-value of money, and is making short-term bets (such as shorting Obama-Michigan at 15, when he wasn’t even on the Michigan ballot) that permit him to free up his bankroll. And when there are thousands of dollars of dead money in there bumping up Ron Paul to win primaries where he has no chance, that’s a lot of money for the taking.

Jay February 12, 2008 at 8:34 pm

Cliff:

Sports prediction markets are invariably bound by the large sums of money that are thrown at the bookies in Vegas. If the Vegas line is trading at a InTrade equivalent price spread of 40-50, then anytime the InTrade price floats outside of that range there is an arbitrage profit(go long with a bookie and short on InTrade) to be made that pulls the InTrade price back in range.
The Vegas bookies drive the momentum and InTrade follows. Within the range prices shift based on traders deciding which side of the spread to stay biased towards.

Paul N February 12, 2008 at 9:41 pm

If a 6% return in 3 months isn’t good enough for you, how the heck do you explain all the contracts for sale at 0.1%? After commission, you’d be losing money by selling these, and Intrade claims they are not market making…

Cliff February 12, 2008 at 11:29 pm

Jay,

Perhaps you don’t realize that bookies are de facto prediction markets? The lines are set by the bettors, not the books. You basically repeated what I just said. Although, Vegas is increasingly irrelevant to sports lines.

BiJian Feng February 13, 2008 at 1:51 am

There wasn’t a 10% for Ron Paul to win the Republican primary in retrospect. Just as it is obvious now that McCain will win the primary, but that wasn’t so when the bets were made. In fact, McCain had less of a chance than Ron Paul according to Intrade.com several months ago. Easy to belittle the odds after the fact. That being said, Intrade still suffers from lack of liquidity. It’s hard to find contracts (other than at ridiculous prices) for lesser known candidates. Intrade has to reduce the transaction costs to be a better predictor.

burger flipper February 13, 2008 at 3:16 am

And some inefficiencies are pretty tasty, even unsalted:
“BTW, another pick I was gonna make that’s no good anymore due to the length of time this is taking: For about two weeks, there were ~25 Hillary shares for sale between 80-90 in MI. She’s the only one on the ballot there and Obama/Edwards write-in votes don’t count, but apparently it took two weeks for somebody else to figure that out and buy them up. Inefficient market ftw.”

http://forumserver.twoplustwo.com/showthread.php?t=88375&page=7

Jed Christiansen February 13, 2008 at 8:22 am

The biggest problem with people assessing the “success” of most prediction markets is that most people have problems understanding probabilities.

If every favourite won, the market would actually be pretty inaccurate! Sports bettors understand this, but when it’s applied to other fields journalists and others tend to forget about it. I’ve written more about the phenomenon here:

http://blog.mercury-rac.com/2008/01/25/how-to-interpret-prediction-market-results-on-elections/

I agree that InTrade would likely be even better if the market had more people participating, but that doesn’t make it inaccurate.

Best regards,
Jed

DK February 13, 2008 at 8:40 am

shouldn’t the probabilities from intrade be assumed to be risk neutral probabilities and not actual expected probabilities?

To the extent the contracts represent events with real economic value, we should expect people to use them to hedge rather than to place bets. e.g. buy Hillary contracts if you work in banking and stand to lose if she starts ripping up mortgage contracts.

Dan Weber February 13, 2008 at 12:05 pm

The second problem is that the market seems to react to new information too slowly.

I’ve commented about this in other places. I expect financial markets to snap near-instantly to news, but it took InTrade a good hour or so to react to the news of Clinton in New Hampshire.

Mason February 14, 2008 at 10:40 am

“The expected rate of return in InTrade is negative; the expected rate of return in the stock market is seven percent minus commissions. Where would you rather put your smarts to work?”

As prediction markets grow more popular and are used to find valuable information (when to fire your ceo, where to locate your company, ect) business will subsidize the markets, $1 bet brings a $1.03 reward as given in an above example.

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