Comments on: What do IEM prices actually mean?

By: jaytee20

jaytee20 — Sun, 26 Sep 2004 06:04:51 +0000

I reccomend http://dir.salon.com/tech/feature/2000/11/16/election_prediction/index.html?pn=2. My condensation: IEM performance was sneer-worthy in 2000. And as long as such a market is relatively small, it is subject to substantial distortion from the source of funds which drive it. The “psy ops” possibility deserves much more consideration than the preliminary efforts at analysing these markets have contained. The Bush gang likes to project a sense of inevitability, of fait accompli. Given the size of these markets, could the Bush price be propped up, for strategic reasons? If you study these markets, right now, without allowing for this latter possibility, I say your work is ipso facto useless.

By: jaytee20

jaytee20 — Sun, 26 Sep 2004 06:04:06 +0000

By: jaytee20

jaytee20 — Sun, 26 Sep 2004 05:59:25 +0000

By: Neel Krishnaswami

Neel Krishnaswami — Fri, 24 Sep 2004 21:26:38 +0000

Neel, this [orange juice price futures predict cold snaps] is an urban myth, they don’t. I appreciate the correction. I recall reading about it as an en passant comment in one of the articles in Dennis Mueller's anthology Public Choice II, and as a result I considered it reasonably credible. So I take it this is a myth in the style of Steven Cheung's "Fable of the Bees"?

By: James B. Shearer

James B. Shearer — Fri, 24 Sep 2004 19:56:08 +0000

Manski’s model is unrealistic in that it assumes people will invest (bet) the same amount regardless of how different the market price is from their estimate of the correct price (true odds). If you assume instead the amount bet is proportional to this difference, then the market clearing price will be the weighted (by amount available to invest) average of the investor’s estimates of the correct price. And the volume will provide an indication of the spread in the estimates of the correct price.

By: Alex

Alex — Fri, 24 Sep 2004 19:41:26 +0000

restated by Taleb on pg. 284 of ‘dynamic hedging’(sorry for no link:) “[an asset’s distribution] will exhibit a bulging right side that would illustrate the lognormality effect… [T]his will result in an increase in the risk-neutral frequency of observations to the left to maintain the fair dice condition in the environment. Such increase in observations is needed to compensate for the difference between the payoff to the right and the payoff to the left. The value of the bet will therefore drop.” A bit confusing and counterintuitive I realize, but obviously accurate when you look at modeled values.

By: Alex

Alex — Fri, 24 Sep 2004 19:12:24 +0000

dsquared an example might be instructive here. an ordinary at-the-money binary call on some generic lognormally distributed future, swap or asset will in the absence of skew always be worth less than the same put. On the order of 55%/45%—try it out, you’ll see what I mean. this as I understand it is a function of the lognormality of the underlier. I’m sure you’d agree such a disparity should NOT exist in a binary market on vote shares. That’s why its especially appropriate here.

By: dsquared

dsquared — Fri, 24 Sep 2004 18:53:40 +0000

Victor might have a point here: I’ll try and pick up the math fonts and confirm.

By: dsquared

dsquared — Fri, 24 Sep 2004 18:23:01 +0000

One of the classical examples is that orange juice price futures do better than the National Weather Service in predicting cold snaps in Florida Neel, this is an urban myth, they don’t. I looked into this one a while ago, and so far, the best that the market-ideologues could do (in critiquing Richard Roll’s original work on the FCOJ futures market, which showed that the contracts were far too volatile to be providing any realistic forecasts of supply) was to show that FCOJ futures made a reasonable job of responding to subzero frosts in Florida as they happened, not predicting them. In fact, as the film Trading Places featuring Eddie Murphy and Dan Ackroyd reminds us, 40% of the entire volatility of the September FCOJ contract takes place on the day when the NWS unveils its Florida growers’ forecast, which would not be consistent with the market having any forecasting advantage at all. Alex, Nnyhav; there is probably an exact model for options on ratios in Wilmott (my copy is a little bit too far to be bothered getting it), but I would be flat out amazed if B-S gave completely wrong results in the case of the IEM. Given the standard deviations of vote shares, the issue of “boundedness” of the distribution would only become a factor about 5 sd from the exercise price, and I just don’t believe that there is enough state-price out in that part of the distribution to make much of a difference at all.

By: Victor

Victor — Fri, 24 Sep 2004 18:16:24 +0000

I disagree strongly with many of your interpretations of Manski’s paper. A few examples: In Manski’s model, this weighted average is not a meaningful measure of the central tendency of the distribution of beliefs, other than that the true average belief has to fall somewhere within fairly wide bounds of the market price, these bounds being determined by the distribution of the size of trading accounts. In Manski’s paper, the bounds are determined by the price itself. He makes no statement about the underlying distribution of the size of the trading accounts, nor about the underlying distribution of beliefs. The easiest way to see this mechanically is in eq. 2 … pi-m is the only variable (pi-m is the market price). Intuitively, Manski’s point is that the market price only tells you that the seller’s belief was between 0 and pi-m while the buyer’s belief was between pi-m and 1. The market therefore is an imperfect information collector; as a result, information aggregates are likewise imperfect. Assumption 2) was always unrealistic Indeed. Assumption 2 forms the best-case argument for the efficient market hypothesis’ conclusion that price is a sufficient statistic for all private information. Relax assumption two, and the case gets worse. See his first paragraph on page 4, or the last paragraph on page 9. Notice that in either event—with a relaxes assumption two or without—the broad bounding problem remains. This is because the fundamental argument he is making deals with the imperfect collection of information rather than the size and distribution of wealth. My prior post on this subject (also see the comment section): http://www.deadparrots.net/archives/economics/0409candid_admission_time_what_does_tradesports_tell_us.html

By: Alex

Alex — Fri, 24 Sep 2004 18:02:45 +0000

nnyhav, modeling-wise i suspect that your point concerning the shape of the underlying distribution is quite right. I’m not a quant but i recall skew being distinctly important to modeling binaries properly* (see Taleb) more even than volatility. I suspect there exists a model somewhere (maybe Garman Kohlhagen or a variant???) that is capable of rendering premia on probabilities with greater consistency than Black or Black-Scholes—perhaps you know of one? options on ratios having surely been pitched by some bank or insurance company at some point in recorded history. *in my book, “consistent with other binaries on the same underlier.”

By: Neel Krishnaswami

Neel Krishnaswami — Fri, 24 Sep 2004 15:37:50 +0000

This is a naive question, but why is it considered a bad thing that traders in an information market have access to polls and forecasts? One of the classical examples is that orange juice price futures do better than the National Weather Service in predicting cold snaps in Florida, and the reason is precisely that the traders can combine forecast information with other information (which, following Hayek, we might call tacit knowledge).

By: Alex R

Alex R — Fri, 24 Sep 2004 15:30:06 +0000

The other Alex makes a nice point about the lack of commercial utility of IEM and similar markets. Ordinary derivatives markets have two major types of participants: speculators, who believe they have some superior knowledge that will enable their trades to “beat the market”, and hedgers, who have some extra-market risk that they would like to use the market to lay off. The speculators are, of course, essential for liquidity and to ensure that contracts are correctly priced, but the hedgers are not only a source of stability, but are also a big reason the markets exist at all. The IEM/Tradesports markets, due to their small size and perhaps other restrictions, will be almost useless for hedging. For example, suppose that I manage a small defense contractor that expects to make 10 or 20 million dollars a year selling components for experimental missile defense systems to the Pentagon or its contractors. If I think Kerry is likely to kill or cut back the missile defense program if elected president, I might be well advised to try to purchase a derivatives contract paying some millions of dollars if Kerry is elected. But the IEM/Tradesports markets just aren’t big enough for this. I don’t know what the research says about how the proportion of “speculators” versus “hedgers” affects how derivatives markets work, but I would expect that the lack of true hedgers would make IEM and similar markets quite different from, say, commodites futures markets.

By: James Surowiecki

James Surowiecki — Fri, 24 Sep 2004 15:19:15 +0000

“There is no particularly strong ideological or practical reason to be against markets just because they’re markets.” My sentiments, exactly. Like Alex, I think the Kerry prices seem awfully cheap, though this may just be wishful thinking. What I remain intrigued by is the fact that although IEM’s WTA market is pricing Bush as a prohibitive favorite (Manski’s strictures aside for the moment), the Vote-Share market is predicting he’ll only get 51.6% of the two-party vote. I realize there’s no obvious way to read off from one market to the other, but that gap still seems pretty wide to me.

By: Alex

Alex — Fri, 24 Sep 2004 14:06:58 +0000

Do the probabilities implied by IEM/Tradesports, lacking the risk management value or commercial utility of IR/forex/commodity options &swaps, contain any valuable knowledge to anyone other than punters and pundits? Whether they are efficient or not (and in the sense of no meaningful arbs I think they are) is anyone going to base any worldy decision on their results? arguments toward the IEM’s marginally superior predictive value seem to lack sufficient data, and long haul averages don’t account for some spectacular last minute flameouts (Dean shares spring to mind.) FWIW I have recently found IEM to lag the bigger and deeper Tradesports market. Speaking as a punter, .075/.080 on Kerry >=52% of the pop. vote does seem awfully cheap, as do Kerry’s odds overall. (Disclaimer: I lost half my account value “catching the falling knife” of Ross Perot shares in ‘96.) I strongly some wishful thinking by certain well funded Repubs, or perhaps something more coordinated?