Forecasters cashing in on predictions
On Tuesday we had the momentous news that the politician whose hair has its own Twitter account was reappointed as a government minister.
Peter Dunne's return to the front bench as Minister of Internal Affairs, after resigning in April over a leaked Government Communications Security Bureau report, was no surprise to some. Over the previous weekend, trading on the iPredict platform put the probability of his ascension at more than 90 per cent.
For the folk who created iPredict - basically a bunch of academics from Victoria University in Wellington - the outcome is another sign that markets are good at predicting outcomes.
But if iPredict works as a forecaster it is at least partly because it offers the opportunity to make money.
The Dunne prediction was derived from a tradable contract which paid out $1 if he was made a minister before this year's election and zero if he wasn't. At the end of last year the contract was priced at about 85c, which would have turned into a 17 per cent profit in just three weeks for anyone able and confident enough to buy it.
That sort of thing tends to attract attention from people interested in making a buck, but is iPredict an investment option or just a fancy betting shop?
Easy - it's a fancy betting shop. But that doesn't mean it isn't worth a second look.
There are about 7000 people signed up as traders on iPredict, of whom about 600 are regular users. Some of them have hefty sums in their accounts - according to the website, the top 100 traders have accounts ranging from $500 to $19,000.
Of those, one of the most successful appears to be the trader known as Economist, whose account was last week worth about $6600, having earned a return of 9834 per cent. Another, mrh, has a return of 78763 per cent, but he or she appears to be playing with much smaller stakes.
Unlike financial markets, iPredict exists primarily as a forecasting device rather than a money raising machine, but it uses money as a tool to tell what people really think.
You reckon David Cunliffe will be the next Prime Minister? Put your money where your mouth is. The more sure you are, the more you will be prepared to pay to get $1 if he wins. For the record, last week the market was picking a slightly less than even chance of a Labour PM, while a National PM was slightly higher than even.
Investors with shares in electricity companies may find a contract like that a useful hedge - with Labour's power policy likely to affect their shares negatively, a gain on an iPredict Labour victory contract could ease the pain.
The way the market works looks relatively straightforward. iPredict is regulated by the Financial Markets Authority as a futures dealer and money in traders' accounts is held in a separate trust account, so there are standard legal protections for users.
The cost of trading is relatively low - the site charges a 2 per cent fee on withdrawals, but only on accounts that have made a profit. Trading fees are 0.35c per share traded, capped at $5 a month.
Because of its mainly academic purpose, iPredict's administrators tend to choose events of general political interest as subjects for contracts and it is legally barred from offering contracts on sporting events.
Traders are invited to suggest ideas for contracts, but that's just to help administrators decide what to offer.
"It has to be based upon whether we think traders will trade it - we don't want to put contracts up no-one's interested in," says market analyst Robert Quigley.
The most popular contracts are on the general election and the official cash rate.
Speculation on the Act party's future has lately been climbing the rankings.
Most of the contracts offer a simple scenario - if the event happens the contract pays $1, if it doesn't, the holder gets nothing.
When a contract is first offered its price is set by administrators and the site runs a market-making function to continually offer buy and sell orders around the market price. When a trader matches one of those orders the trade goes through immediately and thereafter the market price is set by the last trade.
The setup exposes iPredict to some risk and Quigley says the site generally ends up slightly in the red. "If [the initial pricing] is wrong someone will just trade it down until it's right and that'll cost the website a little bit of money, but that's not an issue."
One reason there are risks is that with some contracts iPredict is offering prices in a market full of insiders. On the Peter Dunne contract, for example, some people would be well-placed to know the likelihood of his appointment and unlike on the NZX they are free to trade on iPredict.
The market also has a close relationship with PR consultant and political player Matthew Hooton. Hooton's firm Exeltium provides some free PR for iPredict and was previously contracted to run its marketing in exchange for some say in the contracts offered - which may give potential traders on Act-related contracts some pause for thought.
Quigley says insiders are welcome because they help make the market's predictions more accurate and their presence will usually become apparent by the rapid movement of a price towards zero or $1.
Some contracts can't have insiders, such as whether National or Labour will win the election, but others allow the possibility of inside information. Examples on market include whether the Reserve bank will raise the official cash rate this month and what Fonterra's milk payout will be.
The implication for traders is that on some contracts if you are not an insider, you are the mug.
iPredict looks fun, but it's not a place for serious money.
OTHER PREDICTION MARKETS
Regulatory concerns forced the closure of a real money market run by Irish company Intrade last March. Intrade subsequently disclosed its accounts had a cash shortfall of US$700,000. Intrade was also subject to legal action by the US Commodities Trade Futures Commission, which forced it to stop offering contracts to Americans because of restrictions in the US. However, there remains a prediction market in the US, Iowa Electronic Markets, run by the University of Iowa. It allows traders to have accounts of $5 to $500, although it operates in a legal grey area with "no action letters" from authorities. The IEW offers contracts on US monetary policy and the Congressional elections.
Sunday Star Times