Comments on: Aren’t most firms using binaries for their internal prediction markets? http://www.midasoracle.org/2007/10/26/aren%e2%80%99t-most-firms-using-binaries-for-their-internal-prediction-markets/ Prediction Markets + Market Predictions = Collective Forecasting That Pays Off Mon, 22 Mar 2010 11:07:54 -0400 hourly 1 By: Byrne Hobart http://www.midasoracle.org/2007/10/26/aren%e2%80%99t-most-firms-using-binaries-for-their-internal-prediction-markets/#comment-16409 Byrne Hobart Fri, 26 Oct 2007 15:27:59 +0000 http://www.midasoracle.org/2007/10/26/aren%e2%80%99t-most-firms-using-binaries-for-their-internal-prediction-markets/#comment-16409 Given low enough transaction costs, each contract is a proxy for other contracts: let's say we're betting on voter turnout, and we have contracts in 5% increments: turnout will be above 40%, 45%, 50%, etc. When estimated turnout increases from 43% to 44%, all of these contracts go up -- the only difference is the 'delta' (change in derivative price compared to change in price of underlying indicator), so a clever quant would just write a short script saying, roughly, "Find me the cheapest way to bet that turnout will be 47%, with a standard deviation of 3%," which should yield a melange of long and short positions in various contracts, to be rebalanced as prices (and thus deltas) change. The Arrow-Debreu framework is great, as long as computation is cheap (it is!) and transaction costs are minimal (we'll get there!). Given low enough transaction costs, each contract is a proxy for other contracts: let’s say we’re betting on voter turnout, and we have contracts in 5% increments: turnout will be above 40%, 45%, 50%, etc. When estimated turnout increases from 43% to 44%, all of these contracts go up — the only difference is the ‘delta’ (change in derivative price compared to change in price of underlying indicator), so a clever quant would just write a short script saying, roughly, “Find me the cheapest way to bet that turnout will be 47%, with a standard deviation of 3%,” which should yield a melange of long and short positions in various contracts, to be rebalanced as prices (and thus deltas) change.

The Arrow-Debreu framework is great, as long as computation is cheap (it is!) and transaction costs are minimal (we’ll get there!).

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