Manipulating Prediction Markets

A reader (Alex) followed up on a recent post on prediction markets with the following interesting question:

Does this have an impact on accuracy of betting markets?

http://www.poorandstupid.com/2004_10_10_chronArchive.asp

It’s interesting is that "market" corrected itself relatively quickly, but lower volume market (Iowa) could be more susceptible to someone willing to take large (short-term) loss.

It's true that lower volume markets like the Iowa Electronic Markets are more susceptible to manipulation, because of a concept we finance nerds call "depth". This is a measure of how much a trade of a given amount moves prices. Lower volume markets have less depth, so it takes a smaller trade to move prices.

Manipulators by definition make betting markets less predictive. The reason that these markets are normally good at aggregating information about beliefs is that profit-maximizing investors have incentives to trade on their beliefs. For a contract that pays off $1 if an event occurs (like, for instance the “Bush gets elected” contract), it’s pretty easy to show mathematically that a rational individual would be willing to pay an amount equal to the probability that the event will occur. In other words, if you believed that Bush had a 45% chance of winning, you’d be willing to pay $0.45 for the contract that pays off a dollar if Bush wins.

If market players are motivated by making profits, and the price of the contract is below their assessed “fair” price (in the above example, assume that it was $0.40), they’d be willing to buy the contract. As they buy the contract, the price goes up. It will go up until there is no more perceived mispricing (i.e. until the price is at $0.45).

However, a person might be willing to trade at prices they don’t think are accurate. The article gives an example of a “speculative attack”, where someone puts in an order at an obviously low price in hopes of causing a selling panic. If successful, they will wait until the other sellers drive the price down and then purchase shares on the cheap. Their hope is that they can make more money on the cheaply bought shares than they lost on the unrealistic earlier “triggering” trades.

Another possibility (also mentioned in the article) is that someone wanted to create the perception that Bush was unlikely to win. So, they sold the contract to drive the price down in the hopes that people who watch this market start saying “look at what people are saying with their money – Bush has no chance of winning”. Since prophesies are often self-fulfilling in the world of politics, it could conceivably started a negative buzz that helped torpedo perceptions about Bush’s chances.

In a market like the Iowa Electronic Markets, a relatively small trade can move prices quickly. Likewise, an individual could give money to other operatives (the limit to the amount than can be played on the Iowa Market is $500) and also have them trade to magnify the effect.

Unfortunately, unless someone was willing to keep selling (note: they can do this even if they themselves don’t own the contract by executing what’s called a short sale), the price would quickly rebound, since other investors would perceive the contract as being underpriced. Therefore, the other participants would start buying, until the market is back in equilibrium (i.e. the price is back to “fair levels).

So, speculators or manipulators can make the contract temporarily mispriced, but markets quickly correct. The one case where this might fail is if an individual was willing to keep throwing money away for non-profit making reasons. I’m sure, for instance, that Soros probably has enough spare change in his couch to corner the whole Iowa Electronic Market, so it’s definitely possible. As to how likely, I’ll leave that up to the conspiracy theorists. Besides, I’m running late – I have a black helicopter to catch.

The College Debauchery Index (From Motley Fool)

At the beginning of my Principles of Finance Class, I usually solicit questions from my students (i.e. what questions about the world of finance would you like to get the answers to in this course?). Invariably, at least one asks "What's the Dow Jones Average?", or "What's the S&P?" So, I usually spend at least part of an early class on the meaning of a stock index. Now, thanks to the folks at the Motley Fool, Ihave a new favorite index to show my students: The College Debauchery Index:

If there's a group of people who know more about debauchery, I haven't met 'em. Have you folks seen those Girls Gone Wild videos? Heavens to Betsy... I mean, I've only seen the ads, of course, but there's enough there to convince me that the weekend behavior of today's college kids makes yesteryear's Animal House antics look like a church supper.

So props to a well-organized group of college students who have stepped away from the keg and tap to analyze this behavior and model an appropriate stock portfolio based on the results. Behold the glory that is the College Debauchery Index.

Click here for the whole article.

More On The Costs Of Sarbanes-Oxley

In the next installment of the ongoing saga on how Sarbanes-Oxley makes being a public company prohibitively costly, we have two items (one anectdotal, and the other from a summary from Red Herring):

In the first Steve Bainbridge (at Professorbainbridge.com) send us to this article by Amity Shlaes detailing how the owners of Sungard engineered an $11.3 billion deal to take the company private.

In the second, Jeff CornWall at The Entrepreneurial Mind points us to an article from Red Herring that indicates only 10 venture-capital backed companies filed IPOs in the first quarter of 2005. However, buyouts are continuing at their usual pace.

Stay tuned - I'm betting we'll hear more and more of these reports shortly.

Brad DeLong on Marxism and Exploitation of Workers

This is a Brad Delong recently received this email:

From: "XXXX" XXXX@berkeley.edu
To: delong@econ.Berkeley.EDU
Subject: Communism
Date: Mon, 4 Apr 2005 14:22:30 -0700
Thread-Index: AcU5XGg0e/rUmG6pRfqAi7kFYayhrA==

I was wondering if I could borrow some of your insights on Economics.... I have taken Transitional Economics and have a healthy background (for an undergrad) of the “Economics of Shortage” and decision making under socialist constraints.

However, reading Das Kapital and other things, I am seeing a different interpretation of how an item is valued, and the value of labor verses what I have been taught in traditional classes and I need more understanding. What is the “value” of a product, or of labor? Marx argues that exploitation in capitalism is structural, because the basis of making a “good deal” is paying someone four dollars for something worth five. To be a capitalist means you have to exploit the true value of their labor for what you’re willing to pay them for it.

I was hoping to get your insights into how products and labor are valued, and what you think of exploitation in capitalism. Any help you can provide would be greatly appreciated, even if it is a referral to other books or anything. Thank you in advance.

XXXX

He answers the email by way of this example (click on the link for the whole thing). He concludes:

...Marx's labor-theory-of-value-schema makes no distinctions between profits on capital that have their origins in luck, theft, and choosing the right parents on the one hand; and profits on capital that have their origins in sacrifice, industriousness, or flashes of genius on the other. They are all, to Marx, "exploitation," "unjust enrichment," "extraction of surplus value." They are all, to Marx, signs of evil. But in this particular example the proprietors are, in reality, not evil. The proprietors are, in reality, public benefactors. The effect of their savings and investment is to raise not just their own incomes (after an extended period of sacrifice) but everyone else's incomes as well.

Thus the labor theory of value category of "exploitation" does not map onto what either ordinary language or our moral intuitions call "exploitation."

definitely worth a read.

Legal Finance (From Overlawyered)

Overlawyered brings us this story on "legal finance".

The mushrooming "legal finance" industry offers to advance injury claimants cash on the barrel, to be repaid only if their suits are successful. Some firms have charged effective interest rates exceeding 100 percent a year, but the business generally operates beyond the reach of moneylending laws and has mostly escaped the sort of hostile attention that has been directed at say, the payday loan industry and its alleged "predatory lending". That may be changing, however. New York Attorney General Eliot Spitzer (who says he gets only unflattering attention in this space?) has reached settlements calling for clearer disclosure of fees from at least ten litigation-cash-advance firms, including one based in New Jersey which billed a client $19,000 for a cash advance of $3,000 two and a half years earlier, later accepting a smaller sum. (Joseph P. Fried, "Waiting To Settle a Lawsuit? Beware of Cash Advances", New York Times, Apr. 4). For a glimpse of how the business sometimes works, see Barbara Ross, "Costly trip for Zongo family", New York Daily News, Feb. 14.

There are similarities between these contracts and "payday" loans or (loans in sub-sub-prime markets), but these loans are more like option contracts than anything else. They are paid off only if the plaintiff in the lawsuit wins. So, calculating the interest rate on the loan based only on the cases where the contract gets paid off drastically overstates the return the lender is getting.

Sources For Bond Price and Trade Data

This New York Times article, "A Few Tools For Do-It-Yourself Bond Trading" mentions some excellent sources for bond data. Of these, www.investinginbonds.com, a Web site run by the Bond Market Association is definitely worth a look. On their website, you'll find:

• A good section on "bond basics"
• News about bonds and bond markets
• Data on recent trades and prices
• Coverage of all major markets (corporate, federal government, municiple)

The Web makes bringing real world data into the classroom easy (particularly if you have a net hookup and a projector in the room).

VCs are Flush with Cash (From The Entrepreneurial Mind)

This in from Jeff Cornwall at The Entrepreneurial Mind:

Venture Capitalists were busy raising money in 2004 and have some very full pockets of cash. The phenomenon is known as overhang, and you can read about it here.

More cash means more deals and probably a little bit looser purse strings with the investments they are willing to take. Good times are ahead for high potential ventures looking for money!

Looking at the article linked above, of the $82.6 billion raised in 2000, a fifth has yet to be invested. So, the VCs have the equivalent of a free-cash flow problem - they have more available investable resources than they have good investments. My guess is that this will result in their investing in some start-ups that they wouldn't have taken otherwise. For a corporation, this would be the equivalent of taking on negative-NPV projects. That's good for the startups, but bad for those investing in the VCs funds.