by Dennis Yang
Wed, Feb 13th 2008 4:52pm
Online prediction markets like Intrade have started to make a name for themselves in this year's exciting political arena. By trading futures on political outcomes like the Democratic and Republican presidential nominations, the idea is that the efficiency of the market will ultimately serve as a better predictor of outcome than traditional methods like exit polls. However, as some traders are starting to find, prediction markets still have many inefficiencies in their current state, allowing shrewed traders to make tidy profits as a result. In the Intrade market, a political future is worth $10 if the political outcome occurs, and $0 if it does not occur. Therefore, a $5 market price on a particular future is supposed to correlate with a 50% prediction of that future to occur. However, in practice, certain factors push these prices out of the range of their realistic probability. For example, contracts for Ron Paul's predicted as high as a 9% chance of him being selected as the Republican nominee, when in reality, his chances were probably closer to nil. Perhaps driven by a small cadre of Paul supporters, the Intrade market was able to be swayed by a small number of trades. Even today, Intrade shows Paul at a 1.2% -- which is a great opportunity for someone to make money on taking the short side of that contract. On the Democratic side, Al Gore supporters have put a 1% chance on his head, who never even appeared on the ballot -- wishful thinking indeed. That said, the limited amount of volume on these contracts precludes anyone from actually making a crazy amount of money on them, but it does remind us of an important fact about markets -- while they do tend to come up with the right answer in the long term, in the short term, they are incredibly susceptible to very human factors like optimism and group think.
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