Risk Markets And Politics

Friday, June 30, 2006

The Open Question About Prediction Markets

So enough about hedging for a while.. Let's talk about prediction markets as such. Can we throw away all of the open questions on prediction markets but one?

As Robin Hanson succinctly put it, "the whole idea of prediction markets is that someone who wants to know the answer to a question might be willing to pay to create a market to entice traders to help answer their question." Identifying these sponsors along with the best means of subsidization and the best way to aggregate diverse, knowledgeable traders is THE open question of prediction markets. Real-money markets whose primary purpose is to reveal information and that provide no significant risk-sharing, capitalization or entertainment value must be subsidized, otherwise no-trade conditions will snuff-out activity. Why trade against someone with better information unless you are consciously paying them for it? (This could be what Chris Masse means when he says that aggregating information is not the primary purpose of prediction markets — that a pure prediction market is an imaginary locus.) And needless to say, the market participants can't be in a position where they would be able to otherwise comparably profit from their information without the market structure.

There is also a trade-off to the sponsor in terms of making such markets public in order to attract as diverse a set of traders as possible. Insofar as the sponsors consider the information they are seeking to be valuable, maybe they don't want to make it immediately public through an open market?

If the markets are subsidized via market-making as with a market scoring rule, this presents another reason why binary options might not be the best fit for aggregating information: the sponsor is exposed to much higher percentage losses.

There is no general overarching answer to "the" question, but rather many specific answers that depend on identifying individual niches and inefficiencies. Once these are identified, issues such as interpreting prices are secondary. Promoting corporate prediction markets does approach a general answer however, and here the subsidization happens by way of the company paying for the infrastructure and letting employees' time be diverted, as opposed to direct real-money market-making. Not that corporate prediction markets must operate with play-money. It's not too hard to imagine employee-traders being rewarded by varying their end-of-year bonuses by market winnings or losses, and perhaps the markets could be shuttered during normal working hours to mitigate any time diversion.

Here insider-trading laws may intrude, which brings-up the legality issue that many, including myself at one time, have considered to be the most important open question on prediction markets proper. But perhaps the legality issue is a little overrated and US-centric? Real-money markets in much of the Anglosphere and play-money corporate markets are relatively untouched by it, and there may be some viable strategies for US-based firms seeking to operate hybrid markets. More on this last point in the coming weeks...

Retail hedging?

Hedgestreet is taking a lot of heat lately from bloggers who focus on prediction markets. Steve Roman has labeled their official strategy of catering to retail hedgers an "imaginary niche". If this is the case, why? Consider that both John Delaney of Intrade and Robert Dubil, Hedgestreet's Chief Economist, have recently stated that many traders prefer binary markets because of their greater volatility. One would expect retail hedging of things like home and gasoline prices to occur in long-dated index contracts, not short-dated options. Hedgestreet offers both capped futures and options, and experiences better volume on the options side. The futures side seems to be dwindling, and almost has a vestigial feel to it.

Even the CME doesn't offer housing futures more than one year out although the contracts were originally touted for their hedging utility. The low overhead of running an electronic market combined with the aggregate wealth of potential retail hedgers seems outweighed by the danger of liquidity cannibalization. In other words, it's not worth introducing long-dated contracts that would cater to retail hedgers because these might dilute the liquidity of existing short-dated markets. How much of the lack of retail hedging is reducible to attitudes towards risk versus education and ease-of-use? Or is the public smart to not hedge certain risks?

It could be that the general population is not risk-averse with respect to some prices, or that many do not even perceive their risks. For instance, on the latter count, Robert Shiller and others combat the notion that housing prices drift permanently upwards. Even if risk appetites and perceptions are partly responsible for the lack of retail hedging, this may not be the most cogent answer to the question. After all, the person who is likely to sign-up and trade in an online market is typically a speculator (and possibly a "sensation-seeker"), so basing this conclusion on the dearth of retail hedging in that particular environment could be misleading. Maybe it's just that electronic auctions are not the right means for retail hedging?

At the beginning of the month, General Motors and Ford introduced sales promotions that amount to gasoline hedges. GM's "Fuel Price Protection" program provides new car buyers with pre-paid gas cards that cover the cost of any gas above $1.99 per gallon. What if such cards were offered at gas stations and sold at a premium to current fuel prices? Or cards that entitled their holder to X gallons of gas, a la the USPO's plans for the "forever" stamp? What if similar features were offered as credit card promotions or as capabilities embedded in private banking websites? The idea would be to push hedging instruments at the general public "on the ground" so to speak, in environments where their utility will be especially tangible, and in which their usage will be straightforward, or at least much more straightforward than setting up an account on an online exchange and explicitly trading options.

The pricing of these new "user-friendly" options would of course be somewhat less clear to consumers, which is why someone might want to sell them, and this brings us to the last possibility: that the public is largely wise to not want to enter hedging markets. To what extent would hedging be taking a guaranteed loss? Are premiums and transaction costs fair? Now, you could say "Wait a minute - many insurance premiums aren't 'fair' and that's a huge business." Yes, but there is a practical difference between hedging against a massive and irreversible loss and hedging against an incremental, reversible one. A crash in the housing market could qualify as the former for some, but in those cases the education and ease-of-use perspective would seem to be more apt.

Maybe housing and even gasoline prices just aren't volatile enough to spur retail hedging, and the public won't reach for the morphine drip until it experiences more pain.

Sunday, June 25, 2006

The Poker Face of Wall Street

The July issue of Active Trader magazine has an excellent interview with Aaron Brown, head of credit risk architecture at Morgan Stanley and author of The Poker Face of Wall Street. This is a must-read for anyone interesting in "prediction markets" and the supposed moral aspects of gambling. Brown contends that gambling plays an important economic function, a function in many cases more important than official market purposes such as hedging. He has even claimed that, "Serious poker is a positive sum game." Here are some excerpts from the full article:
Because if the markets are all about price discovery and capital allocation, then they're really like used bookstores. But it sure doesn't look like a used bookstore, and traders make more than people who work in used bookstores.


And I started thinking that it couldn't be a coincidence that credit-fueled volatility and clearing came at the same time, at the same place. Also, I noticed that if you jumped in a body of water near every city that had a poker game named after it and every city that had a futures exchange, you'd float down to New Orleans.


The conclusion I came to was that you have to have a lot of gambling, because you have to move a lot of goods randomly around and you need a lot of people who are good at matching up random goods. Because if you tried to manage the economy just in terms of what the downstream people want vs. what the upstream people want, you'd never get anywhere near the optimization and speed that actually occurred.


[John] Law's ideas about credit and volatility, which are only beginning to be appreciated today, combined with the Native American network economic principles, grew into the modem global economy.


You have to make things jump around and shake them up — then you can get to your new optimum. As a result, you add some risk in the derivatives market. It's like taking an economy and shaking it up a little bit so it can settle down to a better optimum.


Without the right game, the right people don't show up.


If you really believe that finance is not gambling, you do stupid things. You design insurance products that people don't want to buy, and you misprice them. You don't understand why stocks are so volatile, and you mismanage portfolios. You miss the point of commodity, currency, and fixed income markets.

The book contains a foreword by Nassim Taleb that describes the "ludic fallacy": thinking of risk or randomness as something that can be defined, as with the throw of dice. In real life one is never quite sure of the rules of the "game", or what game one ought to be playing.

Another book of interest is 1990's Gambling and Speculation (of which JC Kommer was kind enough to mail me a copy). The authors Reuven Brenner and Gabrielle Brenner make a distinction similar to Taleb's but with different terminology:
The reason for using the word 'speculation' (or 'betting on an idea') is that when individuals carry out the act they do not have enough evidence available to prove whether they are right or wrong. This situation is in contrast to the gambling situation. The latter refers to situations that have been and can be repeated many times, and where the probabilities as well as the monetary gains and losses are the same for everybody and well known.
Since poker involves bluffing, it's a more rich and realistic game than something like blackjack with respect to "legitimate" financial markets.

Wednesday, June 21, 2006

Infrastardom in America

This week's Economist piece on inequality in America shows why "minimizing variance in wealth" is an incomplete caricature of (left-leaning) distributive justice:
Inequality is not inherently wrong —— as long as three conditions are met: first, society as a whole is getting richer; second, there is a safety net for the very poor; and third, everybody, regardless of class, race, creed or sex, has an opportunity to climb up through the system.

I fretted over the first criterion in the last post, where I also cited Robert Shiller's proviso, "We will tolerate substantial income inequality. What we surely do not want is gratuitous, random and painful inequality." I take "painful" inequality literally, to mean lack of habitable shelter, food and basic healthcare. This is essentially The Economist's second criterion, although the healthcare aspect isn't clear and merits a separate discussion. The Economist's third criterion stresses meritocracy. This is also what Shiller is aiming at with his reference to "gratuitous, random" inequality, although he is likely saying something stronger. "Gratuitous" suggests that more than just equality of opportunity is required, and that outcomes should be commensurate with merit. It implies, for instance, that if human abilities or propensity to work are normally distributed, there is something objectionable about wealth tending towards a Pareto distribution. This is a more precise characterization of left-leaning distributive justice than "minimizing variance in wealth".

America is a major engine of entertainment in the world (sports aside), an area where income seems to be particularly disproportionate to innate talent. A number of papers have examined the winner-take-all aspect of stardom. In 1981, Sherwin Rosen observed that, "small differences in talent become magnified in large earnings differences, with greater magnification of the earnings-talent gradient increasing sharply near the top of the scale." Moshe Adler later argued that superstars may emerge even among the equally talented. His work and others stress the role of the public in the production of stardom, where the social dimension of consumption means that, all else being equal, one will prefer what others prefer. This can cause initial random advantages in popularity to snowball. We can see why anyone who clings to the intrinsic theory of value would find this frustrating. (By the way, what is the intrinsic value of watching soccer compared to its social value?) More recently, in a strange and original paper, "Untalented but Successful", Olivier Gergaud and Vincenzo Verardi test these claims by considering the prices of Pokemon game cards. Their findings corroborate Adler.

Thursday, June 15, 2006

Robert Shiller and the Gordian Knot of for political philosophy

Tyler Cowen asks the possibly rhetorical question, "What is new and essential in political philosophy?" and meets a wall of silence. One commenter aptly notes, "What's astounding is how much distributive justice dominates the political philosophy scene. Justice has become nothing more than the question of how to cut the cake fairly or how to manage emergency room resources in triage." To what extent does political philosophy take justice to be synonymous with minimizing variance in wealth? To what extent is minimizing variance in wealth incompatible with raising average wealth? It is safe to say that insofar as it's possible to do both simultaneously, the solution requires more expertise than that commanded by philosophers "who don't know any actual psychology, economics, or statistics". What then is the contribution of Philosophy? To ask, but not to answer — that's its remaining husk. (Even in countries where philosophy is celebrated, it subsists as a fascinating though impotent Hegelian exercise in web-spinning and knot-tying.)

In The New Financial Order, Robert Shiller adopts a similar principle of distributive justice to that of John Rawls. Specifically, "We will tolerate substantial income inequality. What we surely do not want is gratuitous, random and painful inequality." As with Rawls however, we can still ask to what extent is it possible to remove "random" inequality without lowering average or aggregate wealth. By no means do we wish to lump Shiller (nor Rawls) in with the clueless Left and other futile thinkers, or to imply that he doesn't appreciate these difficulties. Some find the fascination with hedging to be unhealthy and counterproductive, but Shiller is quick to outline cases where risk-sharing encourages productive risk-taking. Nonetheless, the question stands.

Considering Shiller's "macro markets", if GDP has an upwards bias, do we really want to hedge it directly on any significant scale? Hedging is usually done to lock-in an otherwise variable spread that corresponds to some profit margin, which in turn causes wealth to accumulate. Even before transaction fees, hedging directly against a drift will only result in less wealth — unless the situation is quite morbid, in which case the hedge is only treating symptoms.

Shiller's "inequality insurance" is a more obviously Rawlsian idea. Inequality insurance would replace the system of taxation based on tax schedules with one explicitly designed to prevent growth in income inequality. Under this "insurance", the government would determine the total amount of taxes raised and after-tax income inequality (by fixing the Gini coefficient of the Lorenz curve). Again, what becomes of total income? By lowering relative wealth isn't there a significant danger of reducing absolute wealth? Shiller addresses this question and suggests that framing the tax as insurance will mitigate incentive effects at higher income levels. This is doubtful and Shiller doesn't make any strong claims on this point, admitting that incentive effects might very well limit the feasibility of inequality insurance.

Robert Shiller doesn't profess to being a political philosopher, but some of his ideas have a certain resonance with the difference principle, or "maximin". Again, the problem with Philosophers as such is that they ultimately aren't equipped to provide answers. Even if one agrees with them in principle, their lack of technical expertise puts any solutions they venture in peril of spawning undesirable side-effects, or even of having the opposite outcomes from those intended. Unlike economists, philosophers seem particularly vulnerable to neglecting the adjustments that agents will make under new systems. Maybe "reducing variance in wealth" is an incomplete caricature of Left-leaning distributive justice, but even so, the above concerns apply.