Prediction markets: betting on risk management

Risk Management, April, 2004 by Russ Ray

Risk managers looking for critical data needed for successful risk analysis and subsequent risk hedging would be well advised to consider prediction markets. Also known as decision markets, prediction markets have consistently proven themselves to be accurate predictors of a wide range of future events. This article examines these markets and discusses their considerable potential for use in risk management.

Prediction Markets Defined

Prediction markets are markets in which people bet on the outcomes of all types of events--political, economic, catastrophic, scientific, financial cultural and so on. The most famous prediction market is the Iowa Electronic Market (www.biz.uiowa.edu/iem) where anyone can bet up to $500 on U.S. politics. Established in 1988 this market has correctly predicted the outcome of every U.S. presidential election since its inception. Moreover, it typically predicts the percentages of votes garnered by the major candidates to within less than one percentage point, consistently producing more accurate results than even voter polls and expert opinion.

There are many other notable predication markets as well Some deal in real money like the Iowa Exchange while others use artificial money that can be traded in for prizes. At the Foresight Exchange (www.ideosphere.com) people can bet on the outcomes of nearly every conceivable event in categories that include news. politics, arts and entertainment, finance, religion, disasters, and science and technology The NewsFutures Market (us.newsfutures.com) is another comprehensive prediction market that offers betting on the likelihood of specific events occurring in the realms of politics, economics, science, natural disasters and more.

As its name implies, the Hollywood Stock Exchange (www.hsx.com) is a prediction market that allows people to bet on the fortunes of Hollywood film and their movie stars. This market consistently forecasts the opening-weekend revenues of major movies more accurately than even the movie industry's own official forecast. At the 2003 Hollywood Oscars, this market also correctly predicted 35 of the top 40 Oscar nominees.

The range of prediction markets is as varied as the public's interests. TradeSports (www.tradesports.com) and the Athletic Stock Exchange (www.athleticstockexchange.com) specialize in sports and current events, while Long Bets (www.longbets.org) is devoted to long-term predictions. There is even a market solely for German political and economic events called Wahl$treet (www.wahlstreet.de).

Meanwhile, private companies have put their own versions of these markets to use in their own operations. Hewlett Packard uses prediction markets to generate unofficial forecasts of its sales. Impressively, its prediction market has predicted H-P sales more accurately than the company's official forecasts 15 out of 16 times.

According to a July 2003 Wall Street Journal article, Credit Suisse First Boston analyzed prediction markets in 2003 and found them to be "uncannily accurate" in predicting a broad scope of events.

The Origin of Prediction Markets

Interestingly, prediction markets trace their origin to the 1600s, when scientific research was practiced quite differently than today. At that time, a few major universities held a virtual monopoly on research, recognizing only each other's theories, and refusing to recognize the theories and research of "outsiders" who were not part of their inner circle. Many of these outsiders argued that their theories should be judged by empirical standards, and not by whether or not their results agreed with the prevailing wisdom of the inner circle. In an attempt to dismantle the teaching monopoly that a few British medical schools held on setting medical practices, chemical physicians in the 1600s--barred front teaching in the inner circle medical schools--offered the following wager in 1651, as cited by Allen Debus in his 1970 book, Science and Education in the Seventeenth Century:

"On ye Schooles ... Let us take out of the hospitals, out of the camps, or from elsewhere, 200 or 500 poor people, that have fevers, pleurisies, etc. Let us divide them into halfes, let us cast lots, that one halfe of them may fall to my share, and the other halfe to yours; ... we shall see how many funerals both of us shall have; But let the reward of the contention or wager, be 300 Florens, deposited on both sides: Here your business is decided."

For reasons that can only be conjectured, this concept lay dormant for more than three centuries until the late 1900s, when prediction markets suddenly flourished.

But How Do They Work?

The mechanics of these markets are essentially those of a horse race. Instead of entering a horse, a person enters a "claim" in a prediction market. A claim is simply a statement that something will happen by a certain time.

For example, currently, one of the claims in the Iowa Electronic Market concerns the outcome of the 2004 Democratic National Committee, which will determine the Democratic nominee for President of the United States. Claims can be made for John Kerry, John Edwards and the other major Democratic candidates.