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Terrorism futures, again

December 19th, 2003

The idea that speculative markets can be used to forecast political events hit the headlines a while ago with the furore over terrorism futures. This idea is still around and the general claim that political events can be forecast by futures or betting markets is still being pushed hard. The main source of data is at the Iowa Electronic Markets, but there’s plenty more. Reader Jack Strocchi sent me this report on a study of Australian betting markets and elections.

As it happens, I’d already looked at this and come fairly rapidly to the conclusion that the betting markets weren’t much good, so I was struck by the money quote from author Justin Wolfers

The data suggests the Australian betting market is extraordinarily efficient. And why not? There’s a huge incentive for participants to do their homework, collect reliable information and make sure the price is right.”

Looking at the report and also the Iowa studies, the evidence in support of this claim still seems very weak to me. In 2001, for example,

The night before the election, Howard was ahead in two of three major polls ….[on Centrebet] Howard was the favorite with odds of $1.55, suggesting a 64 percent probability of his winning the election,”

That is, on the crudest possible use of the polls, two out of three suggested a Howard win, giving odds almost identical to Centrebet. In fact, I doubt that any serious analyst would have given Labor even a 25 per cent chance by election night.

To be fair, Wolfers doesn’t put much weight on the election-night market. He says

data from Centrebet, Australia’s largest bookmaker, demonstrated the impact of current events on the betting odds throughout the nine months leading up to the election, reflecting immediately the electorate’s seesawing response to such events as leaders’ televised debates and the Sept. 11 attacks in America.

In fact, however, the betting markets reacted more slowly than the polls. In this piece written in September 2001, Wolfers and his co-author Andrew Leigh rated Labor a 55 per cent chancebased on the Centrebet data.

But enough of this ad hoc discussion. What test should we be applying here? It’s not appropriate, as nearly everyone in this field has done to treat polls and betting markets as separate predictions. Punters in the betting markets have access to the polls. So they should always do at least as well as any mechanical rule based on poll data. The test “have the markets done better than the polls” implicitly compares the actual betting strategies to the rule “at even money, bet on whichever candidate is ahead in the polls”. Even compared to this simple-minded rule, the improvement shown by the markets is marginal at best.

The real issue we should consider, before rushing to embrace terrorism futures and the like, is how betting markets would perform in the absence of information from polls. You’d have to go back before World War II for this, but it’s my impression that predictions of election outcomes in this period were often way off the mark.

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