Thursday, February 21, 2008

Intrade Prediction Markets as a Sentiment Indicator

Intrade.com is a fascinating place to park your brain from time to time. At this prediction market site, users can buy and sell binary options contracts that allow them to place bets on whether a future event will happen. Intrade has a broad range of contracts that cover everything from whether Osama Bin Laden will be captured by a particular month, which country will host the 2016 Olympics, what the year’s snowfall will be in New York City, and a wide variety of bets about the US election.

Prediction markets have received considerable press and academic attention for their purported ability to provide a better predictive view of the future than that of individual experts. Evaluating the arguments on both sides of this issue is beyond today’s scope, but those who are interested in reading about these claims may wish to start with Prediction Markets: Does Money Matter? by Servan-Schreiber, Wolfers, Pennock and Galebach and move on to prediction markets as a proxy for probabilities in Interpreting Prediction Market Prices as Probabilities by Wolfers and Zitzewitz. For an excellent broad introduction to prediction markets, I recommend Prediction Markets, also by Wolfers and Zitzewitz.

Unfortunately, the volume of trading activity for the financial and economic prediction markets contracts are not as popular as those for politics and entertainment. I do think, however, that there is considerable potential value not only in establishing probabilities for future events, but also gauging investor sentiment. At the moment, the most heavily traded financial contract at Intrade is whether the US will go into a recession in 2008. I have included a chart of that contract, which goes back to August 2007, in the graphic below, which compares estimates of the probability of a recession with the SPX during the same period. While there is a very high negative correlation here (i.e., we have yet another contrarian sentiment indicator working), I find it particularly interesting that the expectations for a 2008 recession peaked just as the SPX was making its January bottom.

If only there were a little more volume in the financial contracts, I suspect there would be quite a few more gems to pluck from the prediction markets. Until then, they are still a great place to get a sense of what the odds are that Barack Obama wins the Democratic nomination or Barry Bonds will be found guilty of one or more of the perjury and obstruction charges he is facing.

1 comments:

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