Monday, September 22, 2008

Arbitrage and US elections

Our US election stock launched a few minutes ago and traders were ready, with stocks in Barack Obama leaping 15 cents in the seconds after its 6pm start.

We launched three contracts: one in an Obama win, one in a McCain win, and a third contract in neither of those two winning the presidency. These three contracts cover every possible result of the 2008 election, and we will accordingly be offering to sell these three contracts in a bundle for exactly (and always) $1.

Bundles make it easy to exploit arbitrage opportunities on the open market. If the combined trading prices of Obama, McCain and Other contracts exceeds $1 on the open market, buy bundles and sell them for a certain profit.

You can also make certain money if the combined value of Obama, McCain and Other is less than $1. Let's say the sum of trading prices for Obama+McCain+Other is $0.97. You can make certain money by buying equal amounts of all three and then sitting on them. The combined payout from the three must be $1, since one and only one of the three contracts must close at $1. You've made a guaranteed $0.03 per contract.

A combined price of $0.97 implies at least one of the stocks in the bundle of three is underrpriced. If you think you can pick which one then your returns increase by buying and holding that underpriced stock until the market corrects itself or the stock closes. But this is also more risky than the certain return on offer by buying all three. As always, risk is traded off with reward.

Remember, there is zero risk when trading a complementary bundle of stocks for a combined price that varies from $1.00.

As I write, the combined price of Obama, McCain and Other is about $1.06. If you are quick enough, there is certain money to be made right now by shorting all three in equal quantity.

5 comments:

Crampton said...

I don't see the option for buying a bundle across the US markets.

You've missed a bigger arbitrage play though: if you've an account on InTrade, can buy Obama shares there for 51% chance of an Obama win and simultaneously sell short on iPredict at 60% chance of an Obama win. Sure, there's then some currency risk across the two markets, but that's a massive cross-market spread!

Crampton said...

Excellent. I'm now long 29 US$10 shares over at InTrade on Obama, short 420 NZ$1 Obama shares on iPredict. Bought Obama on InTrade for 51%; sold it in NZ for 60%; then sold some more in NZ because of the exchange rate. For $385NZ outlay, I have stocks that pay out at $420 NZ if Obama wins and $420NZ if Obama loses. Only unhedged risk is currency!

So much arbitrage, such a tight liquidity constraint. But I'll take a safe 9% return whenever I can find it...

Matt Burgess said...

Nice going.

If there is a negative relationship between a Democrat victory and the value of the US dollar (not implausible - that relationship exists for share prices) then you might expect your unhedged currency risk to undo your earnings on your Intrade contracts! :-)

Crampton said...

I cleared out both positions after Obama dropped to 54% on iPredict :>

Crampton said...

Note discussion by Wolfers over on Freakonomics blog about oddities on InTrade prices on Obama....