Important Fact #2: You can ask (almost) anything

In case you have forgotten already, the first important fact about prediction markets is that they work.

The second important fact is this: you can ask just about any question with a prediction market.

And in light of Important Fact #1, you should expect a robust answer.

Fundamentally, there are two kinds of questions you can ask with a prediction market. First, you can use them to forecast outcomes. Second, you can use them to test policy effects.

Forecasting outcomes is the familiar application to prediction, and the most familar of those applications is forecasting elections. Forecasting future events means using two kinds of contracts.

• Binary contracts: these contracts pay $1 if a defined event comes true, and $0 if it doesn't. Will Clark be Prime minister next year? Will Key? Will the share market be up by today's close? Will petrol cost $3 by Xmas? These are all yes/no questions that a binary contract can answer.
• Indexed contracts: these contracts pay out depending on the outcome of some event that isn't yes/no. For example, what share of the party vote will National get at the election? Labour? By how much will the share market change today? What will the price of petrol on Xmas day be?
  

Binary contracts are actually just a special case of indexed stocks - its just that their indexing ties them two exactly two values of $1 and $0.

To test the effect of policy and decision making, a third kind of contract is required:

• Conditional contracts: these contracts are inexed to a variable conditional on some other event, like a new policy being set, coming true.
  

For example, a contract that was indexed to pay out on the unemployment rate at 31 December conditional on a tax cut occurring some time this year could be used to test the effect of tax cuts on unemployment. The test would work as follows.

Two contracts would be run. The first contract would be indexed to unemployment, conditional on no tax cut. If a tax cut occurs, traders who have taken a position on this stock are refunded what they put in. Otherwise, this stock pays out an amount per share that is indexed to the unemployment rate.

The second contract would also be indexed to unemployment, but this time conditional on a tax cut occurring. Similarly, if no tax cut occurs, traders who have taken a position on this stock are refunded what they put in. Otherwise, this stock pays out an amount per share that is indexed to the unemployment rate.

The difference in the prices these stocks trade for is the prediction market's view on the effect of a tax cut on the unemployment rate.

This prediction relies on the same wisdom of crowds, bottom up prediction methodology that has worked so extraordinarily well when pointed at elections and within firms. iPredict, by the way, is aiming to roll out conditional markets later this year. Stay tuned!