Economic Derivatives Observations

One small bone to pick with yesterday's CME Economic Derivatives reception: Gartman and others perhaps overstated the hedging utility of these auctions. After all, how many traders have exposure to economic releases as such? They probably have fixed income, currency or equity positions and there are already plenty of ways to hedge these. While the economic derivative markets were repeatedly billed as a way to hedge risk "more precisely", it seems that they actually provide traders a hedge with more basis risk, and, more precisely, open-up a new avenue of speculation. One can guess why so much emphasis was put on hedgers, as their image gives the fledgling markets a robust glow and implicitly beckons to speculators. In terms of reducing systemic risk, the fact that the auctions reveal the distribution of expectations might be as important as their use in hedging. Insofar as they are used to hedge against surprises, one might expect the tails to be overbought as is typical for parimutuel auctions, but the degree of this tendency is still unclear.

Now, in a way, ignoring measurement and Goodhart's Law-esque issues, economic derivatives certainly are more precise, and address risks captured only roughly by more established markets. These risks are the sort that develop over time though and might be better served (at least in terms of certain grand visions of risk-sharing) by standing markets as opposed to sporadic auctions on "noisy" releases that are only open to institutions.

It was actually surprising that Dennis Gartman brought-up the IEM election markets. More exciting, he spontaneously asked a representative from the investment bank most closely associated with the auctions if they might extend the infrastructure to political events. While this wasn't ruled out, frequent events with more direct economic relevance were stressed in response. An equity earnings release auction was cited as a possibility.

Interest in earnings release markets was predicted here at the beginning of the year, with the caveat that these numbers are heavily managed and that they are rather easily skewed by a penny or two. Earlier in the week, Victor Niederhoffer described a typically enlightening little study on just this point. The sample of earnings surprises was nothing like a normal distribution, and was quite suspicious in terms of the asymmetry between small upside and downside surprises. Earnings release markets would operate in light of such irregularities.

One can't help but notice that tax and subsidy related markets can be described as political, economically relevant and reasonably frequent. In spite of the arguments in favor of such markets, they would inevitably be somewhat controversial. Perhaps it will take an organization with a certain amount of gravitas to forge ahead in that area, especially in the United States.

Tax Futures

Readers will be unsurprised by this concept, as we've referred to markets linked to legislative outcomes somewhat frequently, especially tax and subsidy legislation. If such markets are to catch-on, it may be possible to hedge against future tax burdens. The $2 trillion tax cuts pushed through by the Bush administration are set to expire by 2011. Budget concerns and a somewhat-related defensive posture by Republicans make it increasingly unlikely that they will be extended. The CBO estimates that lengthening them through 2016 would reduce government revenues by $1.5 trillion. Could a market develop around these large risks?

Consider a set of 0-100 markets predicting the rates of the higher US (inflation-indexed) tax brackets in 2012: {27, 30, 35, 38.07}. Assume that no margin deposit is required or that deposits earn interest, so there is no material cost-of-carry. Since the current bracket rates are {25%, 28%, 33%, 35%} and, without extension, they will revert to {28%, 31%, 36%, 39.6%} in 2011, these prices can be seen as implying a 33% chance of extension.

Setting the markets up in this way avoids referring to any specific piece of legislation or policy. In practice, such markets might not refer directly to marginal bracket rates, but rather predict effective rates for income levels. It just seems more clear to present this example in terms of the bracket rates. Markets based on effective rates and income levels would have to take inflation into account, in which case the interpretation of prices would become more ambiguous. In any case, most of the trading will occur in the higher brackets or income levels.

Some of the earliest and most popular prediction markets (per se) have been linked to elections, but predicting tax rates is much more to-the-point in terms of financial risk-sharing. The existence of such markets would also frame the operation of the government in a way that would encourage fiscal responsibility, and give dispersed interests some recourse against inefficient spending.

At present, it seems that the US tax schedule will either shift upwards or remain the same, but such markets would also allow for pricing the chances of the slope, the progressivity, of the tax schedule changing. To complement the bracket rate markets, contracts could be established to cover the other cuts set to expire such as the estate tax (2011), capital gains/dividends (2009) and the marriage penalty (2009), or AMT-related changes — any piece of legislation that determines one's final tax liability. Markets could also be formed around corporate taxes or more general modifications in the tax code, and might ease the passage of sensible yet otherwise politically infeasible changes, as the interested groups could hedge with one another.

The problem is that in most scenarios, everyone is a natural buyer. Every tax-payer has exposure to higher tax rates, and this may severely limit trade. The natural seller would be the government itself, but this is unlikely since it would probably lose in such markets at the most unfavorable times, as when taxes are raised to bring the deficit under control. Overseas speculators could account for some selling, as could domestic special interests that receive subsidies or industry-specific tax-breaks, suspecting that they might be lost if taxes are brought lower. Alas, the selling from these groups probably would not be very substantial. Contracts related to industry subsidies and tax-breaks would be more feasible in terms of market balance, but those might be better served by OTC arrangements.

In the coming weeks, we'll examine some notable past failed futures markets.

Housing Futures: "Mark your calendar"

Apparently, the launch of the CME housing futures is being pushed-back from next week to mid-May. The margin requirements are still unknown, and their determination is a bit unusual since the historical volatility of the Case-Shiller Index is probably deceptively low.

In general, would it be crazy to suggest asymmetrical margin requirements and/or trading fees in order to make a market more balanced and liquid, at least temporarily?

4/21/06 Update: CME just released an official advisory targeting May 15th as a tentative launch date.

Open Questions About Prediction Markets

Unsurprisingly, the first one is: What is the legal/regulatory future of such markets in the United States? How long will the status quo of unclear, unenforceable laws last? What event will trigger change? Who will lobby for change?

The legal status question actually contains Wolfers' and Zitzewitz's "How can markets attract uniformed traders?" to some extent because two of the answers there are hedging and entertainment (gambling). However, hedging markets invite the regulation of the CFTC, and gambling markets of course are subject to general official prohibition in the US. There seem to be at least three schools of thought developing here. One group invites CFTC regulation in varying forms as the most expedient, if awkward and potentially limiting, solution. Others argue that information markets are conceptually distinct from markets designed for risk-sharing, capitalization or entertainment, and that they deserve their own legal status. Still others argue for full-scale legalization/regulation of gambling. Anyone interested in these topics should read Tom W Bell if they haven't done so already. Additionally, as noted here before, the gambling/hedging distinction isn't very strong in theory or practice. Some are even implicitly questioning the CFTC's service of the public interest as it relates to the risks faced by sports-related industries.

What will be the first major corporate PM success story? The recent Marginal Revolution discussion summarized the issues pretty well. The consensus seems to be that it is just a matter of time, but there are worries. Even in cases where managers are open to being second-guessed and corporate cultures are sufficiently free, maybe the benefits of prediction markets won't be material over the existing implicit prediction/reward structures in firms. Perhaps firms with relatively "flat" management hierarchies already sufficiently approximate the "wisdom of the crowd". Securities regulation, time-diversion, bad incentives and accounting for the effects of hedging on prices are further obstacles. Also, even if traders are anonymous, questions relating to project targets and the like focus open scrutiny on specific managers and divisions, potentially creating a poisonous environment.

As Chris Masse suggested, perhaps external corporate PMs will prove to be more useful than strictly internal ventures. This is plausible so long as the outsiders actually have relevant information. It is a known problem that prediction markets tend to fare poorly in projecting outcomes determined by a relatively small and closed group of decision-makers. Enumerating such problematic cases is another open issue.

Related to the corporate PM success question, one wonders how often will information markets actually be directly subsidized? In order to justify setting prediction/information markets aside as a separate class of market, the information they reveal should be valuable enough that it attracts patrons willing to pay for it. Yes, there are examples of this such as the avian flu market subsidized by the Gerson Lehrman Group, but how common will private subsidization actually be going forward? If US laws are in fact holding back a tidal wave of growth in this area, why aren't there more pure information markets (as opposed to gambling and risk-sharing markets) popping-up "in the wild" where they are legal?

Now, government subsidization might raise the kinds of issues seen with PAM, and this indirectly leads to the next question. How "fit" are binary options as opposed to tradable indices? In the aforementioned Marginal Revolution thread, Emile Servan-Shrieber, CEO of NewsFutures, made a slightly heretical remark on the use of binary markets:

But event probabilities are just not actionable. People in a business environment don't know what to do with them. They need specific numbers. Not "What is the probability that I'll hit my deadline or sales target?" but "What will my sales be?" and "When will I be able to ship this?", or "What will my sales be if I include this feature or that one?".

In many cases an index market will be more practical, especially if it still implies probabilities. In addition to being more actionable, index markets will be less volatile, more conducive to regulation and less susceptible to controversy. What if it is not possible to create a market in binary form, as in the case of Bin-Laden's capture? Ah, well Bin-Laden is a specific individual, and contracts attached to specific individuals or properties seem to be considered insurance contracts by the CFTC. Insurance is regulated at the State level in the US. The CFTC is very unlikely to authorize a future that refers to a specific individual or property, even if all other criteria (e.g. risk-sharing, price discovery, public interest) are met. Such index contracts that refer to some aggregate measure or count are also less likely to invite controversy. What would have become of PAM if it had only priced indices and made no mention of contracts attached to specific (negative) events?

Other questions like contractability and separating causation from correlation are subtle and interesting, but they are also issues outside of the strict prediction market sphere. They are more general problems relating to contracts and market analysis and don't seem to be very threatening in terms of the immediate future of prediction markets.

Even the "calibration on small probabilities" question that largely captured Charles Manski's objections to the "prediction market" label doesn't seem to worry very many people in the industry. One almost never hears about the potentially very severe favorite-longshot bias caused by the fact that most traders aren't paid interest on their posted margin. By "very severe", we mean that a contract tied to an impossible event that expires in one year should only trade down to r/(1+r) where r is the risk free rate, so the "Pigs Fly" 1yr 100 point contract should be worth around 4.5! Play-money contests with rank-order prizes may be vulnerable to similar distortions.

Finally, the manipulation question is largely reducible to attracting liquidity. The argument could even be made that the problem solves itself. Again though, aside from the ways of attracting liquidity mentioned in relation to the first question, manipulation isn't really an issue particular to prediction markets. A variation on Robin Hanson's experiments on manipulation in which traders took the market price as one of their "clues" would however be interesting. Such scenarios, which would exhibit the kind of momentum/trend-following/herding/feedback trading that one often finds in more established markets, might give more pessimistic results with respect to the potential success of manipulation.

Like Wolfers' and Zitzewitz's list, this wasn't meant to be exhaustive. Please add anything that might be missing, or comment on what might have been overplayed.

4/12/06 Update: In terms of "subsidization" above, this specifically meant paying traders for the information they are revealing, although paying to upkeep a market is also a kind of subsidy.

In the case of HSX, third parties pay the owners/maintainers of the market, who do not pass this on to the traders. This is an interesting model that points to PMs replacing traditional test-marketing groups, a trend flagged here before. Of course, the trading itself has to be entertaining in order to attract uncompensated participants. It also doesn't hurt that 1) HSX has been around since 1996, which enforces the "just wait" answer to the PM success questions, and 2) One suspects that HSX is largely a poll and, in any case, traders don't have to devote time to uncovering information, apart from watching movies.

Likewise, one wonders what kind of creative thinking is going on at WSX, especially in light of the Data Warehouse story.