The Power of Free Markets…

Editors Note: We would like to welcome Bill Speth, VP of Research at CBOE. Bill and members of his team may comment in your community from time to time about items the CBOE research group comes across — new products, contract settlement, questions they get from investors or professional traders, etc. We are thrilled to have Bill share his thoughts and comments with all of us.

Bill has worked in CBOE’s Research & Product Development group since 1995. He is involved in all aspects of the product development process, from idea generation & evaluation to contract design & launch implementation. Bill has worked extensively to develop and support CBOE’s VIX product complex as well as other products based on several of CBOE’s other volatility indexes. In addition to his other responsibilities, Bill oversees CBOE’s Custom Index Calculation Service. He has been a member of the World Federation of Exchanges (WFE) Statistics Advisory Group since 2005. Bill holds a MS in Electrical Engineering from the University of Rochester and a BS in Physics from LeMoyne College. Bill currently lives in Evanston, IL with his wife of 26 years. They have four children ranging in age from 25 to 19.

I have a confession to make… I’m obsessed with prediction markets. With the election just a few days away, I’ve been following the Presidential markets on Intrade (, [editors note: This is an Irish Exchange, read their terms and conditions, document requirements, fees, etc. before investing] where you can buy/sell “shares” of Barack Obama or Mitt Romney at prices ranging from $0.01 up to $10. Today, for example, you can buy Obama for $6.80 / share. Romney is trading for $3.20 / share. At settlement — when the election results are official — the winner’s shares are cashed out at $10 while the loser’s shares are worthless.

I’ve never actually made a trade at intrade, but what fascinates me is when I compare prices on Intrade with the election polls, I find they often disagree.  For instance, today’s Obama share price suggests a 68% chance that the President will be re-elected, a 2-to-1 edge over Romney. The RealClearPolitics average of the most recent national polls, however, suggests a much closer race with Obama and Romney tied at 47.4%.

The University of Iowa has its own prediction market, Iowa Electronic Markets (, that was set up in 1988 as an internet-based teaching and research tool. Their research compared market-based predictions to national polls for five Presidential elections from 1988 to 2004, and found that the prediction markets were more accurate 74% of the time.

So why are markets smarter than pollsters? The answer seems to be that human beings have a strong incentive to be well-informed when real money is at stake. And in this case, a LOT of real money is at stake, close to $15 million on Intrade alone!

In a similar way, VIX futures are predicting whether the U.S. government will extend tax relief and other stimulus programs or allow them expire at the end of the year. The Equity Derivatives Strategy group at Credit Suisse recently published a research note (Why are Futures Pricing in a 50% VIX Increase, October 20, 2012) that offered an interesting perspective on the shape of the VIX futures term structure and what it says about the market’s expectation of how the dreaded “fiscal cliff” scenario will play out.

Credit Suisse explains that the steepness of the current VIX term structure compared to a “typical” term structure that flattens for longer-dated contracts is the result of two distinct perceptions of risk. There are those who believe that our politicians will resolve the crisis before year-end, and then there are those who believe that the gridlock that plagued the debt-ceiling debate in 2011 will be repeated. As evidence, Credit Suisse generated an empirical distribution of expected VIX values by looking at trading flows and prices in the January VIX futures contract. What they found was a bi-modal distribution with peaks at 15 (bullish) and 24 (bearish). They expect a single consensus view to emerge after the election and legislators begin working (…or not) on addressing the issue.

In the meantime, please take the time to vote next Tuesday. It’s important.