Thursday, October 2, 2008

VP Debate and Prediction Market Volatility

I was watching the VP debate on CNN, and CNN was reporting the reactions of "undecided Ohio voters" to what the VP candidates were saying. Although interesting, it was not satisfying. I wanted a better way to see the real time reactions. Blogs were relatively slow to post, and mainstream media were simply describing the minutia of the debate. What is the solution? Easy. Prediction markets!

I remembered that Intrade has a contract VP.DEBATE.OBAMA, "Barack Obama's Intrade value will increase more than John McCain's following the VP debate"

So, during the debate, I was following the fluctuations of the contract's price to measure the reactions. Here is how the contract moved from 8.30pm EST since 10.30pm EST. (The debate started at 9pm EST, and lasted until 10.30pm EST.)

At the beginning, the contract was below 50.0%, reflecting probably that the fact that Palin was giving reasonable and coherent responses, disappointing perhaps those that were expecting material for a Saturday Night Live performance.

However, at the second 45 minutes of the debate, as the discussion moved into foreign policy issues, the contract started moving up, as Biden started giving more immediate answers, and Palin started avoiding questions and replied using stereotypical, canned answers.

What I found interesting was the significant increase in variance as the debate came close to the end. Prices fluctuated widely during the closing statements of the two VP candidates.

This increased volatility as the contract comes to a close, is actually a fact that we observed consistently in many contracts over time: when the contract is not close to 0.0 or 1.0, the price fluctuates widely as we get close to expiration. While I could explain this intuitively, I did not have a solid theoretical understanding of why.

So, what to do in this case? You simply ask a PhD student to explain it to you! I asked Nikolay Archak, and within a few weeks, Nikolay had the answer.

The basic result:
  • Volatility increases as contract price gets closer to 0.5,
  • Volatility decreases as contract price gets closer to 0.0 or to 1.0,
  • Volatility increases as we get close to the expiration, and approaches infinity if price is not 0.0 or 1.0.
More information about the basic ideas of the model and about the technical details in a later post.