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The market for political futures

KERRY or Bush? With an election in November no opinion poll would dare to predict the race yet. But, perhaps the markets can. President Bush loves the markets. But can he beat them?

Despite what fund managers and investment gurus say (and charge), it is hard to outperform the market - the best prediction of the level of a financial asset tomorrow is its value today.

Keynes had it right when he noted that the stock market was in some ways akin to a beauty contest in a Sunday newspaper - the object is not to pick the face one finds the most beautiful, but the face one thinks other people will on average find most beautiful. So what?

Well, there is a real market, The Iowa Electronic Market (IEM), with real money, which deals in political futures. And its accuracy is startling.

There are good reasons why such a market would be expected to have at least a decent chance of giving as good a prediction to an event as a poll. Markets exist not just to allocate resources but also to aggregate information. They do this well where a number of events combine: a definite action to be predicted; a monetary reward or cost for accuracy or otherwise: liquidity; and a fair trading mechanism. All these IEM has.

Technically, the IEM is futures market. Futures markets are markets where investors trade contracts for goods, such as pork bellies, oil, currencies etc, with delivery (or a cash equivalent) taking place in the future. Typically such contracts are called month-commodity, such as March Wheat. Trading in this involves predicting what the price will be for wheat at the end of March.

Modern finance theory has achieved a deep understanding about the nature of prices in a futures market. Remarkably, the price of a commodity on a futures market is the best predictor of the actual eventual price.

Thus a futures contract on June IBM shares trading at $120 implies that the market expects IBM shares will be $120 at June. There are technical proofs but the essence is this: futures prices are the best predictors of the price in the future.

In the IEM, contracts are on the relative vote share in an election, and pay an amount equal to the fraction of the vote received times $1. Why care?

During the last US presidential election race, for months in advance of the actual vote, the predictions were consistently in favour of Bush. The reality was of course different, Gore and Bush being locked in a see-saw struggle.

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Interestingly, IEM prices switched back and forth throughout this see-saw period. However, polls not only have a significant (3-4 per cent) margin of error - the margin of error itself is not a good indicator of how accurate the poll may be. The problem lies in that an opinion poll is a static snapshot of voter's intentions at that time.

Leaving aside the issue of whether or not those polled report truthfully, it tells little about how the dynamics will change over time. By contrast; a futures market explicitly forces traders to consider this very issue, in a dispassionate manner.

The prediction of the market, especially as the date of the election looms, is in fact substantially closer to the actual outcome than opinion polls and historically lies within 1-2 per cent of the actual outcome. We should not be surprised especially at this: a well-known feature of futures prices is that they converge to the actual price.

The most recent IEM was on the Californian gubernatorial races. Again, IEM price were predicting a Schwarzenegger victory as early as the start of September, when polls were suggesting that the election itself may not even happen.

However, the remarkable thing about the Iowa Electronic Market is that it appears to have good predictive power not just immediately prior to the poll, but in the months prior.

Recent research has indicated that the predictive power of these markets is greater than opinion polls held three-four months in advance. So, perhaps we are a little ahead of ourselves here, but it is instructive to examine the situation as it stands. As of Wednesday, prices for Bush and Kerry were 46 and 48 respectively.

Given the fact that the markets have been in the past within 1.5-2 per cent of the result, this appears to be at the very least too close to call. But given Bush's love of the market, perhaps it is something that he needs to take seriously. It will be instructive and intriguing to see how the market prices evolve as the candidates go head to head. Let the market decide.

Brian M Lucey is a lecturer in finance at the School of Business, Trinity College, Dublin. The Iowa Electronic Market can be found at www.biz.uiowa.edu/iem/

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