Idea Futures Exchanges

There's an interesting and novel concept called an idea futures exchange. It works just like a stock or commodities exchange, in that market prices are set by a two-sided auction of bids and asks. The difference is that, instead of trading shares of a company, or quantities of a good, you're buying contracts which become worth something if a predefined event happens. So, for example, if you believe that George Bush is going to be reelected, you could currently purchase shares of such a contract at $0.53, and if he is in fact reelected in November, the shares become worth $1.00.

At first glance this may look like a glorified form of gambling. But because of the significance of the events being traded, these markets actually provide a very valuable service: information. They aggregate all the knowledge contained by their traders, and set prices that correspond, roughly, with the perceived probability of the event actually happening. Thus, the market currently believes that George Bush has 53% odds of being reelected.

Now, there are some caveats. Besides the fact that the market could be plain wrong in its odds estimation, there are also reasons why the market price wouldn't be the same as the market's perceived odds. There are several factors which could cause this.

One of them is risk management: a good analogy to this phenomenon is insurance. Insurance companies lose money when their customers suffer setbacks such as injury or property damage. Like any profitable business, they make money because they charge enough in premiums so that their revenues exceed their expected payouts. This means that, from a customer's point of view, you can expect that, over your lifetime, buying insurance will probably not pay off. Yet, most people buy insurance, as they should, because the value of insurance in risk protection far outweighs the cost. So, in the case of an idea futures market, a particular contract may have what's called hedge value. If investors perceive the election of George Bush to be bad for the economy, they might buy shares of George Bush as insurance, at prices higher than the actual odds of him being reelected. Similarly, if they think George Bush would be good for the economy, then the market price of Bush's reelection will be below the actual odds. It can be hard to separate this effect from the market price, to derive the implied probability.

Another factor is contract expiration date. Currently, you can purchase a five-year U.S. treasury bond (considered one of the safest investments possible), at a rate which would give you a virtually guaranteed return of 3.64% per year, which would compound to a 19.57% return over five years. The only way you would not receive this return is if the U.S. Government defaults on its loans, and if it does that, you've got bigger problems to worry about. Therefore, no one will pay more than $0.84 ($1.00 / 1.1957), today, to receive $1.00 in five years. In other words, even an idea futures contract which is guaranteed to be worth something in five years, will trade at a sharp discount today. Unlike the first factor, however, this effect can be relatively easily separated from the market price, because U.S. treasury bonds serve as a base of reference.

Despite these and other caveats, the market price of an idea futures contract still provides a very valuable, and usually very accurate odds prediction of the underlying event it is based on. And, as I said, though the market is sometimes just plain wrong about the odds, it rewards traders who can detect this and drive the price in the correct direction, so over time the market improves its predictive ability by giving the best traders more money to trade in the market, and therefore to effect the prices.

I trade on three idea futures exchanges. The first, the Foresight Exchange, uses fake money. The other two, the Iowa Electronic Markets, as well as Intrade, involve real cash, and I've done fairly well, turning a $250 initial investment into $780, in about seven months.

Very good explanation of how buying idea futures on a prediction market as insurance, and time value lead to the price of a contract not indicating exactly the occurrence probability of the event.