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Thursday, August 21, 2003

The Futures On Terror, And A Big Idea - SoBig, In Fact

Prof. DeLong resurfaces the "futures on terror" question with a fascinating post, which we excerpt thusly:

I've been thinking about this argument by Daniel Davies for nearly two weeks now. I've concluded that it is either a brilliant innovative analysis, or utterly barking mad. Unfortunately, I don't know which:

Crooked Timber: Hayekian markets reconsidered : A week late and a couple of dollars short, here are my thoughts on the now defunct Policy Analysis Market....

Mr. Davies then presents a long argument which I am reluctant to excerpt or summarize for fear of dropping a key piece. That said, fools rush in:

...I do want to comment on the fact that a number of bloggers analysed it in terms of Hayek’s concept of tacit knowledge and markets as information-creating social entities.... I'm not inclined to take seriously those critiques based on bubbles or based on supposed inefficiencies of market behaviour, at least not unless they have some explanation of why these are particular flaws of market behaviour, rather than general organisational pathologies of groups of homo sapiens.

...I don't believe that Hayek’s discussion of "tacit knowledge" is relevant to the question of a Policy Analysis Market. The defining characteristics of Hayekian tacit knowledge is that it’s practical, non-propositional and local in time and space. I actually think it’s something approaching a category-mistake to suppose that anyone could be in a position to have tacit knowledge relevant to the question "Is the chance greater than 22% that the government of Saudi Arabia face a coup attempt this year?".

...Why does this matter? Well, it suggests that the prices struck in a market will be informative only if the market is well stocked with buyers and sellers operating on the basis of their own tacit knowledge.

...in order to be an efficient information-creating entity, a market has to have both hedgers or [sic - I think "and" belongs here] speculators. Although speculators are vital to the functioning of the market, you can’t have a market with nothing but speculators. And if you think about it, all the really successful "speculative" markets are ones in which the speculative activity clearly takes place in the context of a two-way market between hedgers. Commodities markets have structural demand from manufacturers and structural supply from primary producers. The stock market has structural demand (for stock) from people who want to save, and structural supply (of stock) from companies who want to raise money. The money market has structural demand from borrowers and structural supply from lenders.

There is nobody (to a reasonable first approximation) who has structural demand for more terrorism. The only people who have tacit knowledge of terrorists and would be considered to be on the long side of the market, are terrorists, who would presumably not be material participants.

If you hate that summary, blame me, and follow the links.

Now, first thought in rebuttal - what about sports betting? The folks with a natural long or short position would be players, managers, and owners. Other than a prospective "Pete Rose exception", these people are barred from betting. Hence almost all of the action is speculative. In fact, the price action does not, as best I know, actually guide any social activity - for example, higher coffee prices encourage production and substitution, and discourage use. What does a higher spread on the Giants game this weekend affect? I think the value is personal entertainment, and little else.

That said, I suspect that tests have been done to see whether betting lines are useful predictors of final outcomes. If they are, then it would suggest that a purely speculative market motivated by personal entertainment can still provide useful predictions.

However, how does one evaluate the accuracy of these predictions? I note that TradeSports has two propositions on the Kobe Bryant legal situation - will the case go to trial, and will a jury find him guilty.

I doubt that court insiders are driving the prices of either proposition. Currently, there are 247 contracts outstanding on the "guilty" question (and about a 35% probability that he will be found guilty, in which case, barring new evidence, I will be outraged). At $10 per contract, the total payout will be, IMHO, small (OK, I got out the calculator - $2,470).

So, the consensus of folks who read the papers and have both too much free time and too much free money is that there is a 35% probability that Mr. Bryant will be convicted. As interesting factoids go, I like it. As a quick quantification of the (cash based) conventional wisdom, I like it. However, how would one back test it, to see if this type of probability assessment is "accurate"? There are plenty of football games to backtest; this trial is, we hope, somewhat unique.

The best one could do is test similar predictions in similar situations, and see if any patterns emerge. Good luck finding useful data. Hmm, can I bet against such a study succeeding?

And how does this connect to the "Futures on Terror"? With "Coup in Saudi Arabia", we are going to have essentially one trial. If "the market" says there is a 20% probability of a coup by year-end 2003, we don't learn a lot come January 2004 whether there was a coup or not. If there is no coup, it may still have been the case that 20% was wildy optimistic, or pessimistic, as of August 2003 - we have very little against which to compare it.

The idea for PAM seems to be, markets work where there is lots of data and feedback, so they should work with very little data or feedback. Well, they might, but how would we know, either ex post or ex ante?

OK, sidebar, and the promised SoBig idea. First, as a PR ploy, if I were on Mr. Bryant's payroll (but not as a lawyer), I would drive down the prices on those two propositions, and whisper to my friends in the press that they should check this objective, market based measure to see how absurd folks really think these charges are. Is that hopelessly evil, cynical, and manipulative? No, I think I am serious - if I really believed in my client's innocence, why not punish the speculators betting against him? However, it might be interesting to see whose sense of ethics is offended by this notion of engaging in manipulation of an unregulated market of dubious legality and credibility, in order to help one's client.

Now, finally, the big idea. The theme is this - set up a futures market in computer viruses. Contracts predict the OS to be attacked, the software to be attacked, and other such techie info. Participants can be anyone - college kids, system administrators across the country, hackers who want to bet on their own success and score a big payday when their virus hits, engineers at Microsoft or Symantec who want to earn a bit on the side (OK, that could be troubling). Anonymous participation would encourage more evil-doers into the market, which would be a good thing.

Sorry, bait and switch - the big idea is continued in the post directly above. Think of it as my uncharacteristic attempt to unbury the lede.

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