Risk Markets And Politics

Wednesday, January 25, 2006

Hedging Against Education Inflation

Some costs such as education and healthcare are difficult to hedge against because there are few willing to take the other side of the trade. Take education, one of the very best investments. The average college graduate in the United States makes about $20,000, or over 60% per year more than those who stopped with high school diplomas. It is easy then to understand why college costs can continue to advance at roughly twice the overall rate of inflation. Education is a major cost for many families, sometimes comparable to housing.

Consider a market that tracked the level of the "College Tuition and Fees" component of the CPI. This market could work very much like the upcoming CME housing futures, with the monthly CPI release acting as a discontinuous "spot" price. Although the current CME CPI derivative operates as a parimutuel auction, a standing continuous double auction would probably be better here. If the futures had a long term length, this would mitigate the occasional hassle (and cost) of having to "roll" them to the next expiration. Remember, the goal is to provide a hedging tool to members of the public who wouldn't otherwise trade futures.

The fly in the ointment of course is that there would be a massive demand imbalance — there would be many buyers, and few natural sellers. (A parimutuel auction wouldn't really address the dearth of sellers, as buyers would have to commit to a certain price range, when really they just want protection from any upward movement.) The basic supply problem is that colleges aren't commodity producers, and barring potential legislation, they aren't in need of a hedging vehicle.

Aside from legislation, is there anything that might eventually threaten to bring education costs down, making such a market viable? Robert Shiller has suggested that communications technology will decrease the demand for professors. Arguably, this trend is underway in the form of some for-profit universities, but any price competition is not yet material — and rightly or wrongly, academic accreditation does not seem to be just a transfer of knowledge.

What about demographic trends? Perhaps climbing retirement ages will help by increasing the supply of working intelligence, but with the constant explosion of knowledge, this is unlikely. It is more likely that lower birth rates in the developed world will do the trick.

Now, if one believes Ray Kurzweil, intelligence might literally become a commodity by 2029. He made a "$10,000" (the effect of interest rates on prediction market prices is almost never discussed — more on this soon) bet to this effect with Mitchell Kapor on longbets.org. Well, it is doubtful whether a machine passing the Turing Test by being able to simulate a human conversation would actually possess the kind of intelligence that, say, employers would pay for. For the sake of argument, let's assume that it would, because this leads to a good example of market design. The Kapor/Kurzweil bet was a one-off, but imagine a standing Turing Test futures market. Now re-consider the education cost futures. The education futures would then be correlated to the Turing Test market, but the former would compel liquidity because of its double hedging function. One should always think about how changing the explicit content of a market will affect hedging demand, liquidity and balance. Often it might be worthwhile to dial the "beta" of a prediction market tied to a specific event below 100% in order to capture more general concerns (and in some cases, make it less controversial.) Even if there is a huge potential hedging function, there may not be enough balance in the market to realize volume, especially if there are existing ways to express correlated views. It will be very interesting to observe the materialization of the new housing futures market, which should be correlated to bonds.

Sunday, January 22, 2006

Exchange Updates

The Chicago and New York Mercantile Exchanges have apparently walked away from the bargaining table. The CME, the largest U.S. futures exchange, had expressed interest in acquiring a 10% stake in Nymex, the predominant American energy and metal futures exchange. The story at this point is that talks broke down, "in part over concerns about the cost of using the CME's electronic-trading system." The greatest cost of the electronic trading is of course incurred by open outcry floor traders. For Nymex seatholders, any bid for the exchange potentially carries a tradeoff between the floor trading rights and equity components of the seat price. In 2005, the 816 Nymex seats more than doubled in value, and a good deal of this was likely due to the equity component appreciating ahead of the IPO, which had been planned for mid 2006. On Friday we learned that General Atlantic increased their bid to $170 million, up from the original $135 million, but seats are still apparently hovering near $3.5 million despite significant gains in crude oil since they first traded there in November.

The industry trend is clearly electronic trading and the transparency it provides. CME's non-compete agreement in energy products with Nymex expires in June. Additionally, a WTI Light Sweet Crude contract is scheduled to begin trading on the Intercontinental Exchange on February 3rd — and Iran is planning to open its oil bourse in March.

Meanwhile, Hedgestreet seems newly invigorated in their push to reach retail clients. Their edge will continue to be the ease of use for the average person who does not otherwise trade futures, and I wish them luck.

1/24/06 Update: There is a report in Natural Gas Week that CME will list energy contracts in June. CME's stock was up over 6% today, and ICE, 10%. There is a graphic on Nymex's web site that says, "Evolution is Inevitable."

Sunday, January 08, 2006

Prediction Market Predictions

Succumbing to the basic human needs to predict and create lists, which are especially prevalent near calendar changes, here are some forecasts for 2006:

Prediction markets can do more than provide information and entertainment. This will be a major theme this year, especially for exchange businesses like Intrade.

  • Further emphasis will be placed on the risk-sharing possibilities of prediction markets. This focus has a double practicality, as it sets the stage both for robust liquidity and favorable regulation. A central issue in the development of sports- and entertainment-related markets in the United States will be the degree to which they provide a hedging function for pre-existing risks. Intrade or another firm will approach film studios and offer them a way to partially insure box-office receipts through prediction markets. Regardless of the outcome of these kinds of endeavors, the regulatory environment will remain more favorable in Ireland, the U.K. and Australia at year-end. The term "peer-to-peer insurance" will gain traction.

  • Interest will grow in applying prediction markets to matters of public choice. Prediction markets tied to tax- and subsidy-related legislation provide strong incentives for "latent" groups to form and give special interests a way to hedge their legislative fortunes. This thread of development will gain momentum before the more ambitious Futarchy, which needs to address how hedging behavior will skew informational interpretations of price.

  • There will be a paper published which models market size and liquidity based on hedging utility, degree of risk-aversion/seeking among participants and the volatility of contracts.

  • Attempts to seriously use prediction markets as a new form of intellectual property will encounter no-trade conditions. Leaving aside publicity bets, in some cases these problems may be overcome by identifying third parties for whom the market's information is valuable enough that they are willing to subsidize liquidity.

On the informational side, corporate internal prediction markets will thrive, led by NewsFutures. Additionally, firms will begin to explore using external prediction markets to replace traditional public test groups. This movement will eventually lead to surprising results in fields as diverse as modeling, advertising, music, publishing, and consumer products. (Fortunately, the sort of network technology that makes this possible will also relieve excessive commoditization.)

2006 will see intensified competition and consolidation among exchanges. Here are some highlights relating to firms involved with prediction markets and alternative derivatives:

  • Intrade's EBOT will face stiff competition from the CME, whose alternative derivative offerings will expand. A major advantage of online prediction markets is their ease of use and expanded client-base versus traditional futures markets. With the EBOT restrictions, Intrade loses this advantage and has to face an entrenched, much larger competitor. Consider one example. Intrade has indicated that it is interested in hosting a weather-related market, but in 2005, CME's US weather derivatives market grew over 350% to 214,501 contracts in volume. Intrade will of course offer distinct contracts, but the only real factor that will keep CME from competing in any new markets will be the latter deeming them too small or controversial to be worth the effort.

  • Plagued by low volume, Hedgestreet's business model will begin to morph into that of a broker. They will explore ways to provide look-alike contracts to CME and NYMEX futures. Instead of hosting markets, they will sell micro contracts internally hedged by the standard futures. The advantage of the smaller contracts to customers will be accessibility and size, while Hedgestreet will capture relatively large commissions. Eventually, the public will be able to hedge energy and real-estate prices as part of standard online banking interfaces. Possibly, the large exchanges will take a more active role in somehow capturing the business of smaller hedgers; given a widely distributed and inexpensively maintained interface, this could be feasible.

  • Investment banks and the CME will have conversations concerning equity earnings-release auctions which would work much like the current economic derivative auctions. This would give sell-side entities a more efficient way to compensate their equity researchers, and would give CME another toe in the equity waters. Unfortunately, it is too easy for the large companies that would likely be covered by such markets to manage earnings by a penny or two each quarter.

  • If CME doesn't actually tender a NYMEX bid, expect NYMEX's IPO to be delayed.

  • Mark Cuban will take an interest in a prediction market business.

Macro-economic and miscellaneous predictions related to risk:

  • Asian reserve policies, savings- and exchange-rates will be the main drivers of inflation, volatility and interest rates, with the latter three moving together in the same direction.

  • Regarding housing, the first point is a real yawner: interest rates will be the main determinate of prices. The second point is more arcane and relates to the new housing futures. As mentioned in the last post, self-fulfilling prophecies tend to be most robust when there is bad information. "Bad" here can mean a few things: 1) Wrong, as when an unfounded rumor causes a bank run, 2) The correct information is insufficiently disseminated, or 3) The correct information isn't released frequently enough. Since the housing futures will settle based on an apparently quarterly index, and there will be massive pressure to sell the index as a function of hedging, there is some chance, however small, that the new futures market will weigh on housing in a self-fulfilling manner.

  • Energies and metals will continue to do well, both on the back of Asian demand and as systemic and inflationary hedges.

  • Byron Wien will check the online prediction markets before making his 2007 surprise list. He cites at least a 50% chance that Mitt Romney will emerge as the likely 2008 candidate at some point during 2006. Tradesports gives Romney a 10% chance of winning the nomination. Experts will continue to overestimate small probabilities as a function of reputational "call-buying" which is made "profitable" by selection bias in public memory.

  • Chatter about the threat of a systemic derivatives "blow-up" in the financial industry is overstated. There will be none in 2006 barring a massive natural disaster, terrorist attack, or - positively - a major technological breakthrough such as a cure for cancer or fusion.

Don't forget the Prediction Markets Summit - East, which will be held in New York on February 3rd. Intrade will take this occasion to let us in on more details regarding their EBOT venture. Oh, and Chris Masse will somewhat surprisingly not renounce his French citizenship.