In Paul Krugman&#8217-s blog entry, Done, at 4:39pm (EDT) on March 21, 2010, he commented: &#8220-OK, nothing is sure in this world. Intrade is still giving Obamacare a 2.2% chance of failing, …&#8221-

He was talking about the InTrade market on Health Care Reform. In theory, the market price in such a derivative market should equal the expectation of the underlying event coming true. However, Paul Krugman (and many others) forgot one of the most basic assumptions of the market model! Transaction costs.

When the market price is over 95, InTrade charges a transaction fee of 3 cents per contract (real money). While market prices are quoted in percentages, the payoff for a winning ticket is $10 (real money). Therefore, the transaction fee is 0.3% of the winning payoff. In addition, InTrade charges 10 cents per contract on expiry (if you &#8220-win&#8221-). That&#8217-s another 1.0%.

So, when the market was quoting 97.8% likelihood of the HCR bill passing before June 2010, this didn&#8217-t really mean that there was a 2.2% chance of the bill not passing. A winning ticket would be subject to 1.3% transaction fees. The real likelihood of failure was 0.9% &#8211- approximating the uncertainty that Obama would be &#8220-hit by a bus&#8221- before signing the bill into law.

No rational investor would wish to purchase a share for more than 98.7, given the transaction costs. In a sense, this is the market&#8217-s &#8220-100%&#8221-. Interestingly, at 1:49pm GMT today (March 23), there are 695 bids at 99.1 and 413 asks at 99.2. Clearly, some traders are not subject to the full transaction fees at InTrade. More about that here.

[Cross-posted from Toronto Prediction Market Blog.]