Posted by: sepalot | October 20, 2008

Manipulation of Prediction Markets

As over the last decade or so, traditional opinion polls seem to have lost power when it comes to precisely predicting election outcomes, prediction markets have grown in importance. Initial research suggests that these markets, in which ‘shares’ of the different candidates / political parties are traded (for real or virtual money), work well in aggregating information and in fact appear to outperform traditional opinion polling (see Wolfers and Zitzewitz, 2004). One such market, the Iowa Electronic Markets organized by the University of Iowa, for instance currently estimates the probability of an Obama victory in the presidential elections as around 86.8%.

One major criticism of these markets is however that they might be susceptible to manipulation for political or financial reasons (see for instance Wolfers and Zitzewitz, 2006). In fact, there seem to have been efforts lately to manipulate the price of McCain options on Intrade, a well-known prediction market (via Marginal Revolution).

Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.

According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts — quickly returning the Obama and McCain futures prices to their previous value.

This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage.

The good news is that market participants quickly became aware of this manipulation, noticing the large differences between the prices of different similar contracts on Intrade and the gaps between prices of similar contracts on Intrade and other betting markets.

For example, the trader purchased large contracts named specifically after McCain and Obama. There were no similar-sized investments, however, in separate instruments that predict a generic Republican or Democratic presidential win — even though both sets of contracts apply to the same event, prices show.

Similar trading patterns were not found in competing predictive market Web sites betting on John McCain , such as the Iowa Electronic Markets or Betfair. This means the trader was paying thousands of dollars more than necessary to purchase McCain contracts on Intrade, where the price of betting on McCain was much higher.

On Sept. 24, for example, Obama contracts were trading on Intrade at a price that predicts a 52 percent chance of an Obama victory. At the same time, Betfair and IEM contracts equated to about a 62 percent chance of an Obama victory, according to the political site fivethirtyeight.com.

The bad news is however that even though the manipulation was apparently rather obvious and amateurishly executed, it was nonetheless pretty successful.

Overall, if the trader’s motive was to influence the Intrade market, he was remarkably successful, Rothschild [a researcher and Ph.D. candidate at the Wharton School] said. The trader’s actions help keep the probability of Obama winning the election on Intrade about 10 percent lower than Betfair and IEM for more than a month.

This is surprising given that once this kind of manipulation is recognized it should be easy for informed traders to profit from it financially, reversing erroneous market movements.

In the end, one may hope that every successful instance of manipulation makes these markets less prone to manipulation in the future. After all, following Hanson and Oprea (2007), every case of manipulation should attract well-informed traders looking for a free lunch and increasing precision of the markets.

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Responses

  1. Unfortunately however the Intrade market did not correct immediately. In fact their prices were out by 8-10% from Betfair’s prices for about 4 weeks. Hansen’s theory of manipulation remains just a theory in this instance.

  2. Well, to be honest, I’ve been so indoctrinated at this point that I think really, really hard before I start trading on things like these. Could it simply be a difference in the exact terms of the contract that is causing this (got burned because of this technicality while betting on Merkel as the new chancellor during the last election in Germany)? Could it be exchange rate related? Could it be that what looks like an arbitrage is really not one once you take the opportunity cost of the money you have to commit into account? Countless questions like these go through my head before I start arbitraging.

    But it is certainly interesting (and somewhat troublesome for the proponents of these types of markets I would say) that the manipulator was so successful at what he did. I’d be very interested in knowing if he would have been even more successful had he committed a bit of money on the other major markets as well. After all, in such cases there are no price discrepancy that anyone can arbitrage away (arbitrage meaning a portfolio having positive payoff in no matter which state of the world materializes). In such cases you must really believe that you have better information than the market does.

    P.S.: “Hansen and Oprea (2007)” is supposed to be “Hanson and Oprea (2007)”, right?

  3. Thanks, typo corrected.


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