Another play money arbitrage explanation, much easier than the last one.
I sat down to the computer this morning at exactly the time emails were arriving from Media Predict announcing the opening of five new markets for the “-Project Publish”- finalists. One of the five finalists will receive a book deal.
In the prediction markets, five new shares were launched at $50 ($ = Media Predict play money). Shares held in the winning book will be paid $100, the others will expire at $0. So, at market launch, selling one each of the five shares would gain $250, and guarantee a payoff of $-100. Result: riskless profit of $150. The market should have launched at $20 each (or, at least, that is one set of prices that would have eliminated the riskless arbitrage opportunity).
First to the new markets, I sold short what I could afford across the board, bringing all the prices down to $35. An hour or two later prices had drifted up on several shares, no doubt due to the enthusiasm some trader had developed for the books, but in their enthusiasm they didn’t realize that they should complement a purchase of one share with sales of other shares – otherwise they leave free arbitrage opportunities in the market. A bit later someone came along and sold all of the share prices down to $20 each.
Now, several hours later, prices have moved much higher on three of the books, while two seem to be drifting lower. I’ve sold some other Media Predict holdings so I could arbitrage some more, but I’m credit constrained in the Media Predict economy so I can’t grab all of the riskless profit. As I write, the current gain from selling a one-of-each suite of shares is $156, so the present riskless profit available is $56.
While the book shares are presented as five parallel markets, actually we have a single multi-outcome market. There are five books, and only one of the five will be selected. Since the sum of the probabilities across the five books is constant, if you think option A is more likely to win then it must be the case that the joint probability of B, C, D, and E is less likely. The market can take advantage of that relationship to improve market performance, for reasons that Chris Hibbert explains in “Increasing Liquidity in Multi-Outcome Claims.” If the market won’t do it, arbitrageurs can.
Note: Chris Masse was puzzled about bigger picture issues in his earlier post on Media Predict, and I comment on some of those issues in response. For the purposes of the post above I’m ignoring the big picture and just wondering about the market mechanism and implementation.