Prediction markets: crystal ball for finance? Also known as 'decision support' markets, these online bazaars may hold the key to better forecasts and improved financial controls.

Financial executives are obviously well versed in forecasting, but they might do well to bone up on predictions--using "prediction" markets in their financial planning and control.

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Prediction markets--also known as "decision" markets and "decision support" markets--are online markets in which people bet on the future outcomes of every conceivable type of event: political, economic, social, cultural, catastrophic, athletic, and so on, including many financial events. The most famous of these markets is the Iowa Electronic Market (IEM) in which anyone in the world can bet up to $500 in real money on the outcomes of U.S. presidential elections.

According to a study by Credit Suisse First Boston, these markets have "proven to be uncannily accurate" in predicting all types of events. The IEM, for instance, has correctly predicted the outcome of every U.S. presidential election since its inception in 1988. Moreover, this market has also predicted the percentages of votes garnered by U.S. presidential candidates more accurately than any other existing forecasting tool, including election polls and expert opinion. In recent years, the IEM has also conducted betting on U.S. monetary policy and selected stock prices and industry returns.

Hewlett-Packard uses prediction markets to generate unofficial forecasts of its sales. Impressively, HP's prediction markets have forecasted its sales more accurately than the company's own official forecasts, 15 out of 16 times.

Another prediction market, the Hollywood Stock Exchange, predicts opening-weekend movie revenues more accurately than the official forecasts of the movie studios releasing the movies.

Table 1 lists some of the world's major prediction markets, and the types of betting conducted in these markets. All of these markets conduct betting, using either real or artificial money, with real cash prizes often awarded to correct predictors in the markets utilizing artificial money. (The Web addresses of these markets can be easily accessed by placing their names into an online search engine such as Google or Yahoo!.) Table 2 lists some of the many financial forecasts contained in prediction markets.

What's the Secret?

Of course, the logical question regarding these markets is: How and why do they predict so well? The answer is that these markets continually flush out and aggregate information from around the world (including inside information), thus tapping into the collective knowledge and wisdom of savvy people everywhere. This phenomenon was behind the Terrorism Futures Market, created by the Pentagon but subsequently terminated when its revelation infuriated many members of Congress.

Prediction markets operate on the same principle as pari-mutuel horse races. Instead of entering a horse, a person enters a "claim" in a prediction market. A claim is simply a statement that a certain event will happen by a certain date. Anyone in the world can enter any type of claim, and bettors will thereafter bet for or against that particular claim.

In a typical prediction market, the holder of a claim coming true receives $1.00, while the holder of a claim not coming true receives nothing. Since a $1.00 payoff represents 100 percent probability (certainty) of an event coming true, and a $0 payoff represents zero probability, the price of a claim in a prediction market is actually the market's consensus probability of that claim coming true.

For example, the Iowa Electronic Market provides an ever-changing set of odds on the Democratic race for the presidential nomination. In mid-February, shortly before the final primary wins that made John Kerry the presumptive nominee, the average "bid" for Kerry was 45 cents, meaning that bettors thought Kerry had a 45 percent chance of becoming the 2004 Democratic nominee. None of the other contenders still in the race garnered bids above 5.5 cents. If Kerry subsequently became the Democratic nominee, based on that person's bid, he/she would earn a profit of 55 cents. Anyone in the world can bet up to $500 (of real money) in this market. Other prediction markets have no betting limits.

For readers familiar with the Efficient Markets Theory, a prediction market is actually an "efficient" market in the "strong form" of the theory. A strong-form efficient market is one that immediately and continually reflects all relevant information, including inside information. In fact, since prediction markets are not regulated and, further, are open 24 hours a day with easy access by anyone in the world, these markets may be the most efficient markets ever.

To sum up, knowledge of the world's best estimated probabilities of future exchange-rate values, global stock-market indices, oil prices, inflation rates, U.S. monetary policy, and even the announcements of the Federal Open Market Committee can be very valuable information. Financial executives may want to incorporate such critical probabilities into their planning and control procedures.

Table 1: Major Prediction Markets

MARKET                    PREDICTIONS

Iowa Electronic Markets*  Financial issues, elections
Long Bets*                Long-term predictions
Wahl$treet*               German economy
TradeSports*              Financial statistics***
Foresight Exchange**      Financial statistics***
NewsFutures**             Financial statistics***

*Real-money exchange **Artificial-money exchange ***Stock-market
indices, exchange rates, etc.

Table 2: Selected Financial Forecasts

NewsFutures Exchange
    Global stock indices
    Exchange rates
TradeSports Exchange
    Gold prices and exchange rates
    Major economic announcements
    Federal Reserve's FOMC announcements
Iowa Electronic Markets
    U.S. monetary policy
    Selected industry returns
    Selected stock prices
Foresight Exchange
    Exchange rates
    Oil prices
    Stock market indices
    Inflation rates
    Business cycles of selected countries

Russ Ray, Ph.D., is Professor of Finance at the University of Louisville. He can be reached at [e-mail].