Insider Trading and Prediction Markets

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					Insider Trading and
Prediction Markets

Robin Hanson
Associate Professor of Economics, GMU
Insider Trading Syposium
GMU, January 2007
Coordination
Coordination            Coordinator Aides:
                          Schedule meetings
                          Collect stats
                          Monitor others
                          Research options
                          Write reports, talks
                          Review proposals
                          Screen candidates
                          Predict outcomes
                          Make choices

       But: Lose Control, Leak Info, Ins. Tr. Law?
Well-Informed Traders (WIT)
 Costs                     Benefits
   Scare ave. investor        Better assign capital
   Less control info/pay      Subsidize info ties
   Risk, Sabotage             Less signaling


  (If no obvious externalities, let firm decide.)
SEC Rules On WIT
   Regular reports required
   Disclose info to all or none
   No trade if info not “available” to all
   “Insider” = Top boss, investor, director
     No short sell, no sell <6mo., report trades
 Failures: Most info not at reports, insider
   trades profit, analysts are WIT, …
 Arguably hinder info process innovation
Other ways to stop WIT profits
   Announce WIT in advance
     E.g., WIT level, trade volume day ahead
     Easier to comply, yet far more protection!
   Flag as WIT on trading offer
   Allow trades orthogonal to firm price
   Always show internal PM stock price
   Let firms decide how/if to regulate
Buy Low, Sell High
                   Will price
                   rise or fall?
   “Pays $1 if
   Bush wins”         sell
                                   E[ price change | ?? ]
                   buy
     price
                   sell              Lots of ?? get tried,
                      buy             price includes all!

             (All are “gambling” “prediction” “info”)
Today’s Current Event Prices
 45-47% The Departed Oscar Best Picture ‟07
   6-9% Bird Flu confirmed in US. By Apr. ‟07
 85-90% Min Wage Increase By Apr. „07
 15-17% Bin Laden caught by „08.
  7-12% US military act against N. Korea by „08.
 18-26% US or Israel air strike on Iran by „08.
 18-24% Dick Cheney Resigns by ‟08
 48-49% Hillary Democrat Pres. Nominee in „08.
 55-56% Democrat President in „08.
 TradeSports.com
In direct compare, beats alternatives
   Vs. Public Opinion
      I.E.M. beat presidential election polls 451/596 (Berg et al „01)
      Re NFL, beat ave., rank 7 vs. 39 of 1947 (Pennock et al ‟04)
   Vs. Public Experts
      Racetrack odds beat weighed track experts      (Figlewski „79)
       • If anything, track odds weigh experts too much!
      OJ futures improve weather forecast (Roll „84)
      Stocks beat Challenger panel (Maloney & Mulherin „03)
      Gas demand markets beat experts (Spencer „04)
      Econ stat markets beat experts 2/3 (Wolfers & Zitzewitz „04)
   Vs. Private Experts
      HP market beat official forecast 6/8 (Plott „00)
      Eli Lily markets beat official 6/9 (Servan-Schreiber ‟05)
      Microsoft project markets beat managers (Proebsting ‟05)
Hollywood Stock Exchange
                        2000 Oscar Assessor Error
                           Feb 18 HSX prices 1.08
                           Feb 19 HSX prices 0.854
                                  Feb 18 Tom 1.08
                                   Feb 18 Jen 1.25
                                  Feb 18 John 1.22
                               Feb 18 Fielding 1.04
                           Feb 18 DPRoberts 0.874
                        Columnist Consensus 1.05

                  Science 291:987-988, February 9 2001
Track Odds Beat Handicappers

 Figlewski (1979)
 Journal of Political Economy




  14




                                Estimated on 146 races, tested on 46
Economic Derivatives Market
   Standard       Non-Farm                 Retail          ISM Manuf.
   Error of        Payrolls                Trade            Pur. Index
   Forecast
    Ave of 50         99.2                  0.55              1.12
     Experts
     Market           97.3                  0.58              1.20

    Sample              16                   12                11
     size
                Wolfers & Zitzewitz “Prediction Markets”
                (2004) Journal of Economic Perspectives
NFL Markets vs Individuals
                         Prediction Performance of Markets
                           Relative to Individual Experts

             0
            20
            40                                                             Average of Forecasts
            60
            80
           100
           120
    Rank




           140                                                                 NewsFutures
           160                                                                 Tradesports
           180
           200
           220
           240
           260
           280
           300
                 1   2   3   4   5   6   7   8   9 10 11 12 13 14
                             Week into the NFL season

                                                   Servan-Schreiber, Wolfers, Pennock & Galebach (2004)
                                             Prediction Markets: Does Money Matter? Electronic Markets, 14(3).
    1,947 Forecasters
   Item      1988      1992      1996      2000       All
   # big       59       151       157       229      596
   polls
   Poll        25        43        21        56      145
  “wins”
  Market       34       108       136       173      451
  “wins”
   %          58%      72%        87%      76%       76%
  market
  P-value    0.148     0.000     0.000     0.000    0.000



“Accuracy and Forecast Standard Error of Prediction Markets”
Joyce Berg, Forrest Nelson and Thomas Rietz, July 2003.
Iowa Electronic Markets vs. Polls




                     “Accuracy and Forecast Standard Error of Prediction Markets”
                     Joyce Berg, Forrest Nelson and Thomas Rietz, July 2003.
 Policy
Analysis
Market
Every nation*quarter:
-Political stability
-Military activity
-Economic growth
-US $ aid
-US military activity
& global, special
& all combinations
Trade Scenario                                  Return to Focus
                                                                           Trade
                                                               Payoffs: If SAum3 03105-125&
                                                                                             Update

                                                                                             Ave. pay
                                                                                                      ?


                                                      Select New Price IQcs403<85 IQcs403>85 <85 65%
                                                      Max Up       95.13% +$34.74 -$85.18      -$19.72




                                               Buy
             Saudi Arabian
         Economic Health
                                                      10% Up       68.72%   +$2.74  -$3.28      -$1.07
       125
                15 30                                 You Pick      65 %    +1.43   -2.04       +0.34
                      70 65                           No Trade     62.47%    $0.00   $0.00       $0.00
            100 40 35
       100 94
                                                      10% Dn       56.79%   -$2.61 +$2.74       -$1.12




                                               Sell
                      35 25
                            30 35                     Exit Issue   48.54% -$15.34 +$26.02       -$6.31
        75            10 10
              1   2   3   4   1 2                     Max Dn       22.98% -$120.74 +$96.61     -$22.22
             03 03 03 03 04 04




             Return to Form                   Execute a Trade                                         ?
              If US military involvement in Saudi Arabia in 3rd Quarter 2003 is not
              between 105 and 125, this trade is null and void. Otherwise, if
              Iraq civil stability in 4th Quarter 2003 is below 85, then I will receive
              $1.43, but if it is not below 85, I will pay $2.04.
                          Abort trade if price has changed?                    Execute
The Fuss:
Analysts often use prices from various markets as indicators of potential events. The use of petroleum futures
contract prices by analysts of the Middle East is a classic example. The Policy Analysis Market (PAM) refines this
approach by trading futures contracts that deal with underlying fundamentals of relevance to the Middle East.
Initially, PAM will focus on the economic, civil, and military futures of Egypt, Jordan, Iran, Iraq, Israel,
Saudi Arabia, Syria, and Turkey and the impact of U.S. involvement with each.
[Click here for a summary of PAM futures contracts]
The contracts traded on PAM will be based on objective data and observable events. These contracts will be
valuable because traders who are registered with PAM will use their money to acquire contracts. A PAM trader
who believes that the price of a specific futures contract under-predicts the future status of the issue on which it is
based can attempt to profit from his belief by buying the contract. The converse holds for a trader who believes
the price is an over-prediction – she can be a seller of the contract. This price discovery process, with the
prospect of profit and at pain of loss, is at the core of a market’s predictive power.
The issues represented by PAM contracts may be interrelated; for example, the economic health of a country may
affect civil stability in the country and the disposition of one country’s military may affect the disposition of another
country’s military. The trading process at the heart of PAM allows traders to structure combinations of futures
contracts. Such combinations represent predictions about interrelated issues that the trader has knowledge of and
thus may be able to make money on through PAM. Trading these trader-structured derivatives results in a
substantial refinement in predictive power.
[Click here for an example of PAM futures and derivatives contracts]
The PAM trading interface presents A Market in the Future of the Middle East. Trading on PAM is placed in the
context of the region using a trading language designed for the fields of policy, security, and risk analysis. PAM will
be active and accessible 24/7 and should prove as engaging as it is informative.



 Became:
PAM Press
 Of 500+ articles, these
 gave more favorable PAM
 impression:
 Article: later in time, more
 words, mentioned insider,
 news (not Editorial) style,
 not anonymous
 Publication: finance or
 science specialty, many
 awards, many readers
       Cummulative number of companies that have
        implemented an internal prediction market
                          (lower bound estimate)

35


30


25


20


15


10


 5


 0
     1997   1998   1999   2000   2001   2002   2003   2004   2005   2006

                                          Source:
              Inputs               Outputs
Prediction             Theory
Markets




       For Same         Compare!


Status Quo
Institution
Not Experts vs. Self-chosen Amateurs
   Forecasting Institution Goal:
     Given same participants, resources, topic
     Want most accurate institution forecasts
   Separate question: who let participate?
     Can limit who can trade in market
   Markets have low penalty for add fools
     Hope: get more info from amateurs?
Advantages
  Numerically precise
  Consistent across many issues
  Frequently updated
  Hard to manipulate
  Need not say who how expert when
  At least as accurate as alternatives
                          Incentives
                   Weak            Strong

         Key                      Decision
Topics
                                  Markets
         Fun
                  Morale
                  Markets
         Money:    Play                Real or Rated
         Time:     Personal            Work
         Shows:    Mood                Outcome, Ability
Estimates from Prices
          $1 if A   p(A) $1

             $x     E[x]   $1

       $1 if A&B      p(A&B)    $1

         $ x if A   E[x|A]*p(A) $1

       $1 if A&B    p(B|A) $1 if A

         $ x if A   E[x|A] $1 if A
Revenue if Switch Ad Agency
                                          $ Revenue if
  $1           $1 if Switch                  Switch
              P(S)
                               E(R | S)
            E(R)                               Compare!
$ Revenue                      E(R | not S)

                   $1 if not              $ Revenue if
                    Switch                 not Switch
Decision Market Applications
  E[   Revenue | Switch ad agency? ]
  E[   Revenue | Raise price 10%? ]
  E[   Project done date | Drop feature? ]
  E[   Project done date | Add personnel? ]
  E[   Stock price | Fire CEO? ]
  E[   Stock price | Acquire firm X? ]
Vote On Values    But      Bet On Beliefs
                 E[ GDP+ | Alternative ] >?
                 E[ GDP+ | Status Quo ]
Decision Market Requirements
   Legal permission       Public credibility
   Outcome                Traders
     Measured               Enough informed
     Aggregate-enough       Decision-insiders
     Linear-enough          Enough incentives
     Conditional-enough     Anonymity
   Decision               Prices
     Distinct options       Intermediate-enough
     Important enough       Can show
     Enough influence
Coordination            Coordinator Aides:
                          Schedule meetings
                          Collect stats
                          Monitor others
                          Research options
                          Write reports, talks
                          Review proposals
                          Screen candidates
                          Predict outcomes
                          Make choices

       But: Lose Control, Leak Info, Ins. Tr. Law?
Other ways to stop WIT profits
   Announce WIT in advance
     E.g., WIT level, trade volume day ahead
     Easier to comply, yet far more protection!
   Flag as WIT on trading offer
   Allow trades orthogonal to firm price
   Always show internal PM stock price
   Let firms decide how/if to regulate