October 12, 2008

Is there dumb money on Intrade?

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A friend recently mentioned that there is dumb money on Intrade, a site that creates markets in various real-life events such as the US Presidential elections. They said that there are still people betting that Hillary Clinton will become President in November. I’m a big fan of free money so I thought I’d check it out. Sure enough, according to Intrade, there is a 1.6% chance Hillary will be elected President, with thousands of dollars worth of contracts available. I’ll grant the chance of Hillary being elected as non-zero, but it must be orders of magnitude less than 1.6%, so what’s going on? It was a quiet day so I thought I’d work out if it was a scam or a bad deal.

Firstly, I checked Google to see if this was a legimate site. It certainly seems to be reputable. There are many mentions in major mainstream media and various blogs use its numbers instead of polls (they have Obama at 77% for the win). Intrade is based in Ireland, so presumably they are safely outside the US’s gambling laws.

Next I checked the financial maths. At the time of writing, the Hillary Clinton to be President contract has a bid of 1.6 with 633 US$10 contracts and an ask of 1.7 with 450 US$10 contracts (with good depth after the top). Thus if it is certain that Hillary will not win, you would sell at the bid price (ie sell Hillary to win contracts at 1.6). You would then immediately earn US$0.16 per contract and if Hillary lost that would be the end. If she won then you would owe US$9.84 per contract on November 6th (the date the contract matures). It would be the reverse if you thought Hillary would win, then you buy contracts, paying US$0.17/contract (the ask price) and getting paid US$9.84 when she won (or nothing if she didn’t). So far so good.

At this point Intrade are making no money themselves, so I went looking for the fee structure. Buying and selling fees change depending on various circumstances, but in this example they are US$0.03/contract. Also there is a US$0.10 fee for holding a contract to expiry. It is possible that you could trade out of the contract before expiry and thus pay US$0.03 rather than US$0.10, but this requires the market to move your way. The worst case is thus US$0.13 of profit will disappear in fees. Now selling the Hillary for President contract makes US$0.03. Not nearly as good as before, but still probably much greater then the chance she will win. I have made a simplification here; it is possible for sellers to reinvest their initial gain if it exceeds the cost of the contract. However this is unlikely to make much difference due to the small size of the profit compared to the investment required. After the cost of the initial trade you would be able to sell 1 extra contract in a reinvestment for every 75.7 you initially sold.

So how does Intrade ensure people pay up if the contract goes against them? There must be some rules about posting margin on your trades in case they go bad. This would only apply to the sellers as they get money upfront and only have to pay their losses – buyers pay upfront and get paid if they win. It was a little hard to find but Intrade’s margin rule is “cover your worst case future potential losses”. That is if you sell Hillary for President contracts at US$0.16 you get US$0.16/contract, but you also have to post US$9.84/contract as margin. This money is held in escrow and as far as I can tell, earns no interest. This is equivalent to putting US$9.84 in a bank and getting US$0.03 in interest an absolute return on your money of 0.3049% (absolute return = 0.03/9.84). However, the money will only be held until the end of the contract – at the moment that is 26 days for Hillary. This makes for an equivalent annual interest rate of 4.37% (annual return = (1+absolute return)^(365/days to expiry) -1 ). A bit better and it gets better still closer to expiry. If the same trade is made next Saturday then the return is 5.7%, the week after that it’s 9.7% (there is a complete table here).

So over short time periods the relative return is good (assuming the prices stay available). So to get a good overall return you would need to keep rolling over your winnings into other dumb bets near maturity. While there are quite a few other unlikely contracts for the US elections (for example, Biden to be dropped as VP candidate), the Intrade markets seem to become more sane after November 4th. There are still some that are possibilities: hurricane contracts closing at the beginning of December; various contracts maturing at the end of the year (Europe to host the 2016 Olympics?); and, the Oscars bets in February. There are financial markets contracts closing every day, but these could be risky (especially given the current volatility). I think trying to roll over profits into other contracts would be like picking up pennies in front of bulldozers, and like LTCM the temptation would be to veer into less certain contracts to maintain return.

An alternative would be to keep money in a bank account and just quickly trasfer it quickly in and out of Intrade – surgical strikes if you will. Moving money in and out of Intrade) does not seem easy enough to justify this. Money can be deposited by credit card or bank transfer without fee. However, taking money out is harder. You can either have a cheque mailed (!) to you or a bank transfer for a US$20 or US$30 fee.

I don’t think there is dumb money on Intrade, just stuck money. Due to the lack of interest on accounts and margin together with the transactional costs of doing a trade or moving money mean that the Intrade market breaks down at the extremes and becomes unrealistic.


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