Friday, September 26, 2008

Obama Contracts, Arbitrage Opportunities, and Manipulation

A few posts back, Matt introduced iPredict's new event derivatives on the American election. I noted in the comments that an arbitrage opportunity existed between prices on iPredict, where one could buy McCain for 40 cents or sell Obama for 60 cents, and InTrade, the Irish exchange, where one could sell McCain for 48 cents or buy Obama for 51.4 cents. I of course then went and did exactly that, taking a nice bit of arbitrage profit across the two markets.

Now, we shouldn't expect to see price differences across different exchanges: arbitrageurs, like me, should work to ensure that prices are the same. And, most of the time, we find that to be the case. Recently, though, it looks as though things have gotten a bit out of whack over at InTrade. Chris Masse, the world's leading, and most bombastic, prediction market blogger[1], provides the evidence. In short, Obama prices have been lower on Intrade than on a host of other exchanges, and it looks like somebody keeps going in to drive down Obama prices while simultaneously driving up Hillary prices. InTrade still has event derivatives on whether Hillary will become the next president.

A couple notes.

First, research by Robin Hanson and Ryan Oprea has shown that the presence of folks who try to manipulate these sorts of markets winds up improving markets rather than hurting them: it means that there's a stronger incentive for each of us informed traders to watch for opportunities to take money away from the manipulators. They're every bit as lucrative to informed traders as are the hard-core partisans who come into the market and just want to buy their preferred party's shares no matter the odds. I traded pretty heavily in the Iowa Election Stock Market back in 2000. As they didn't have an automated market maker (like we have), I often served as market maker, happily selling overpriced Democrat shares to folks coming in to the market who seemed to want to buy lots of Democrat shares, and same for Republicans. Great fun. In short, manipulators and partisans make the rest of us richer and the market more efficient.

Second, a potential manipulator on InTrade provides all of us with a profit opportunity if we're happy to arbitrage across markets. Arbitrage in general is hampered by that it's illegal for Americans to trade at InTrade or Betfair or iPredict. That makes the set of potential arbitrageurs smaller and keeps the field more open for us! All you have to do is open an account with InTrade and make the arbitrage play whenever prices differ across the two markets. Buy Obama at InTrade and sell Obama at iPredict, or vice versa for McCain, whenever the prices differ appropriately. Since folks started pointing out the arbitrage opportunities, the price difference has eroded considerably, but you can still buy Obama there for 57 cents and sell him here for 59 cents. That's probably not worth the candle, but it might be worth keeping an eye on prices in other markets in case of odd price spikes. Risk free profits await.[2]

[1]No, Chris, this does not make me a little Chris Masse fanboy.
[2]Yes, I know there's currency risk, but you can always hedge that elsewhere.


Colonel said...

Intrade looks so much more complicated than iPredict. I would like to play both against each other as you suggest, but how easy is it to get money back out of Intrade?

It looks like they will only send it by "wire" (which I thought was strictly from Agatha Christie books), or cheque (where I presume bank fees would chew up any profit).

Crampton said...

InTrade is a bit more complicated than iPredict. First and foremost, they're a for-profit exchange. So, they do charge some transaction fees that we don't charge. If your contract expires and you're "in the money", there's a small fee. If you accept somebody else's bid or ask rather than placing your own in the order book, there's a small fee. None of them amount to much alone, but they do add up.

Withdrawal is by cheque or wire transfer. The wire transfer option is probably the better one for getting money to NZ. There will be fees with that as well though.

When there's only a 2 cent difference across the two markets, it's not going to be worth the hassle. When there's a 9 cent difference, it definitely is. Just gotta keep an eye out for the spikes.