Prediction Markets
In the Financial Review last friday an article expounded on the concept of prediction markets - that is, markets (fantasy or real) where people speculate on futures based on the probability of a random event occuring, with an associated payoff for that contract if and when that event occurs. The most common example of such a market is any betting agency that takes bets on who will win a sports championship, such as say, the AFL Premiership, or an election, like the upcoming federal election or the presidential election in the US.
Most prediction markets aren't true financial markets monetarily speaking- payoffs tend to be only $1 or something small. However, it was found that these prediction markets tended to be a very good indicator of the probability of the future event occuring, beyond what could be explained by random chance. This is because a prediction market is the purest form of an efficient market: that is, the prices fully reflect all available information known at that present time.
Lets forget about the theory of it. What interests me are the practical applications of a predictions market. Because these predictions tend to be informationally efficient, the predictions can be used as a relatively accurate forecast of expected future events. The key thing to take away from that is that we could mitigate a lot of the risk in our actions today, based on information prediction markets supply.
For example, you're thinking of taking out a home loan tomorrow to buy a house. This is a risky proposition - a home loan for a decent house nowadays could be up to $400 000 (without interest), and you don't know whether repayments can get cheaper, more expensive, or whether it's the right time to buy a house etc. A mistake could cost you tens of thousands over your lifetime, if not cost you everything. So what can prediction markets do for you?
Let's look at the contracts for a number of random events. Find out the underlying determinants of your decision, what can affect it, and see accordingly. What is the possibility of an interest rate increase in the next 6 months? 12? What is the possibility of certain commodities prices (in our case iron, nickel and other minerals) increasing or dropping? What is the possibility of the Shanghai Stock Exchange collapsing in that same period?
If we take the earlier example of a contract paying $1 if the event occurs, we only need to look at the market price for that contract to judge, after all the information has been aggregated, what the expected probabilities of those events are. So, if the market price of a contract of an interest rate hike in the first half of '07/08 is only 33c, we can assume that the probability of a hike NOT happening is 77%. Once all the payoffs for all your chosen economic indicators have been aggregated, you can build a strong base upon which to make your decision.
Of course, prediction markets are exactly that - predictions. There's a chance that it could be wrong. That's the way it works - and thats why I've used words like 'relatively', 'possibility' . However, due to the information efficiency of a predictions market, it allows you to reduce much of your risk in decision making, which in itself can be priceless. Increasingly organisations (especially political organisations) are starting to embrace the use of prediction markets as a better forecast of future events as opposed to tradtional forecasting methods such as polls. Google, ever the innovative company, has been using predictive markets for awhile and find that it tends to be a better predictor for events affecting their company, and the Iowa Electronic Market usually does end up correctly predicting political results.
It just boggles the mind how an idea can have such wide ranging benefits for the community as a whole. Or just plain bore you. Hope it was the former :P
On the facebook front - no takers on the fan club yet =/ So I've decided to join groups that are TOTALLY my bag - first : "hes MY boyfriend, stay the hell away from him" Description: "anyone tired of the stupid bitches that jump all over your bfs dick". Totally.
P.S - classics: "Treat a Man like a Blunt...Hit and Pass" and...
*Why Yo Gurl/Man Blamin' Me Cuz YOU Starin?!*
*Why Yo Gurl/Man Blamin' Me Cuz YOU Starin?!*
*Why Yo Gurl/Man Blamin' Me Cuz YOU Starin?!*
posted by jaseypoo! @ 7:08 PM
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