Monthly Archives: August 2005

Prediction Markets

2008 Presidential Race – current prediction markets forecast

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The idea of relying upon futures markets prices to forecast future events has an interesting history. Nearly 20 years ago, UCLA finance professor Richard Roll published a paper in the American Economic Review entitled “Orange Juice and Weather” which showed, among other things, that the futures market in orange juice concentrate is a better predictor of Florida weather than the National Weather Service. Since the only way one can earn excess profits in a speculative market is to gain an informational advantage over the competition, traders are strongly motivated to try to do just that. If markets are informationally efficient, it follows that market prices represent unbiased forecasts concerning future events. Technically, this means that on average, the market’s estimate of the average value of the event in question is likely to be quite accurate.

Consequently, I believe that political “futures” markets provide reliable indications of the odds that a political party or candidate will win an election.  Although the 2008 presidential election is still more than 3 years away, tradesports.com maintains an actively traded market for futures contracts which pay off $100 in the event that a specific political event occurs and $0 otherwise.  Essentially, prices represent “risk neutral” event probabilities. With this in mind, it is interesting to observe what the political futures markets are telling us at this time about the 2008 election.  Currently, three contracts are traded that involve bets on which party is likely to win the presidency in 2008; specifically, Democrats, Republicans, or none of the above:

Contract
PRESIDENT.DEM2008 (Democratic Party Candidate to Win 2008 Presidential Election) – 48.30% chance
PRESIDENT.REP2008 (Republican Party Candidate to Win 2008 Presidential Election) – 50.50% chance
PRESIDENT.FIELD2008 (The Field (Any Other candidate) to Win 2008 Presidential Election) – 1.20% chance

tradesports.com also makes a market in futures contracts on specific candidates winning either the Democratic or Republican nomination for president.  Currently, Senator Hillary Clinton (D., NY) leads the Democrats (43.7% chance), whereas Senator George Allen (R., Virginia) leads the Republicans (20%).  At this time, it would appear that the Republican race for the nomination is more competitive than the Democratic race; Governor Mark Warner (D., Virginia) comes in second after Hillary with a 10.9% chance, whereas Senator John McCain (R., Arizona) is close behind Senator Allen at 17.2%.  The product of the nomination probability times the party probability listed above represents the market’s best guess at who the next president will likely be.  Currently, the top 5 candidates are as follows:

Hillary Clinton – 21.11% chance
George Allen – 10.10% chance
John McCain – 8.69% chance
Rudy Giuliani – 6.57% chance
Mark Warner – 5.26% chance

Interestingly, the market believes that Governor Arnold Schwarzenegger (R., California) has a better shot of becoming president than the following set of potential candidates: Governor Brian Schweitzer (D., Montana), Retired General Colin Powell (R.), Senator Pat Leahy (D., Vermont), Senator Chris Dodd (D., Connecticut), Representative Harold Ford (D., Tennessee), Senator Joseph Lieberman (D., Connecticut), Senator Elizabeth Dole (R., North Carolina), and Retired General Tommy Franks (R.).  This would quite a feat, since in order for the Arnold to become president, it would require an amendment to the U.S. Constitution (since Arnold was born in Austria).  In other words – not going to happen – not for Arnold, and not for the rest of these “candidates”.

Catastrophes, Economics, Finance, Risk and Uncertainty

Cat bonds

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The very concept of insurance is based on risk. So it’s no surprise that important innovations in risk management and finance often come from the insurance industry. One such innovation that is growing in popularity is the so-called catastrophe bond, or “cat bond.”

Common sense as well as theory suggests that proper diversification of any risk involving a remote possibility of enormous loss (such as a natural or man-made catastrophe) makes such a risk more manageable. Traditionally, catastrophe, or “cat” risk was transferred and shared through the insurance and reinsurance markets. However, in spite of the dramatic growth in the magnitude of human and economic losses from natural and man-made catastrophes in recent years, it is surprising how little cat risk transfer actually occurs. Property owners fail to adequately insure catastrophe risk, and even when they purchase insurance, their insurers tend to retain most (as much as 70 percent) of this risk rather than distribute it more broadly through the reinsurance market. The reason why cat reinsurance is so limited is due to inadequate global capacity and correspondingly high reinsurance premiums.

Cat bonds came into existence due to this lack of capacity in the reinsurance market. Although they have been used primarily as an alternative to cat reinsurance, there are examples of corporations and other non-insurance entities issuing cat bonds. For example, during the summer of 1999, Tokyo Disneyland issued cat bonds because management found at the time that it was cheaper to have the capital markets insure its earthquake exposure than the insurance markets. More recently, the Fédération Internationale de Football Association (FIFA) issued a $260 million cat bond to protect itself against (a terrorism-related) cancellation of the 2006 World Cup in Germany.

Cat bonds represent a form of insurance securitization in which risk is transferred to investors rather than insurers or reinsurers. Typically, an insurer or reinsurer will issue a cat bond to investors such as life insurers, hedge funds and pension funds. The bonds are structured similarly to traditional bonds, with an important exception: if a pre-specified event such as a terrorist attack or hurricane occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or the principal value of the bonds.

Although the cat bond market is still relatively small compared with the traditional insurance and reinsurance markets, it is already having a particularly important effect on reinsurers. Since the cat bond market provides insureds with a credible alternative to traditional reinsurance, the cat bond market has forced reinsurers in particular to become more competitive in their pricing and underwriting practices. Furthermore, investors value cat bonds in part because returns on these securities tend not to be very highly correlated with returns on other asset classes such as stocks, conventional bonds, commodities and real estate.

Given the benefits that cat bonds offer both insureds and investors, the market for cat bonds is expected to continue to grow and exert an important check and balance upon pricing and underwriting practices in conventional insurance and reinsurance markets. Ironically, as documented by a recent Wall Street Journal article, the growth of the cat bond market is in turn fueling the growth prospects of the reinsurance industry, as a number of hedge funds that were early cat bond investors are now starting to launch their own reinsurance firms.