Prediction Markets

Prediction markets are "information markets" where the participants trade in contracts whose pay-offs depend on outcomes of unknown or uncertain future events. Wikipedia defines it as "speculative markets created for the purpose of making predictions". It is based on one of the basic maxims of classical economics - in a truly efficient market the market price will be the best predictor of an unknown future event. Prediction Markets are a generation ahead of the traditional opinion poll method of ascertaining future events. In the most basic prediction markets, the "winner-takes-all" market, the contract costs, say Rs 5, and pays off, say Rs 25 if and only if a specific event occurs. The price on a winner take all market represents the markets expectation of the probability that an event will occur. In an "index contract", the payoff varies in a continuous way based on a number that rises or falls, like the percentage of vote received by a candidate. The price of such a contract represents the mean value that the market assigns to the outcome. In "spread betting", trades differentiate themselves by bidding on the cutoff that determines whether an event occurs or not, like a candidate receives more than a certain percentage of the popular vote.

Evidence from across the globe on different Prediction Markets, most notably the Iowa Electronic Markets which predicts the US Presidential election winner and Hewlett Packard's use of such markets in sales and other business parameters forecasting, indicates that these markets are as good a predictor of events as any.

It is that time of the year when the Government carries out large scale transfers of Indian Administrative Service (IAS) officers. The build up to this merry-go-round varies from 2 to 4 weeks and is a fertile ground for gossip. This year the incubation period has been over a much longer duration, by some estimates it has been going on for the last four months. And it is still counting!
This uncertainty, coupled with the deep curiosity, which drives this gossip market, is an ideal ground for setting up a prediction market on IAS transfers. The market could work some thing like this.

The transfers build up time is normally agog with speculation and rumors about all kinds of outcomes - when the transfers will take place, the approximate number of transfers, the number of Collectors getting changed, which officer is going where, which among two or three officers is going to a particular 'in-demand' post, and the like. Normally there are two or three potential outcomes for each event, and these outcomes add grist to the rumor mills. These rumors are mostly random (though somebody could try plotting a set of these predictions, don't be surprised if it fits into a neat Gaussian distribution!) and un-coordinated. To draw meaningful conclusions from this noise filled communication, it is necessary to have some agency to filter, aggregate and consolidate the information available in the market.

Prediction Markets can step into this vacuum and serve to channelize the rumor babble. In this context, the IAS Officers Association (IASOA) can be the appropriate information exchange and a clearing house for the Prediction Markets on IAS Transfers. The Government can think of setting up a Prediction Exchange headed by a Commissioner Prediction Exchange (CPE). For example, let us assume that there are three strong contenders A, B, and C for the post of CPE! (Fast Forward to 2020, CPE would be the most coveted post under Government of Andhra Pradesh, for where else you can come to know about transfer information even before the Government itself decides it!) An Initial Public Offering (IPO) for CPE can be issued and the Exchange (or IASOA) can issue stocks denominated for each of the three contenders, at say Rs 2 (issue price), and these stocks will then trade in the open market. Buyers and sellers trade in this secondary market and the prices of each of the three stocks at any point of time will be a measure of the probability of that particular officer ascending the CPE throne. In a strong competition, as is the norm for such coveted posts, the fortunes can swing and will be reflected in the fluctuations of the respective stock prices. The IASOA Monthly Newsletter can even analyse the scrips in the various categories, for their betas and alphas!

If for instance, the prices of stocks A, B, and C are respectively Rs 3, 5, and 9, A can pack up and think of some other posting, C can get ready to join as CPE, and B can draw some consolation and redouble his efforts at getting the manna! If the trend is firmed up, investors can sell short and buy long the shares of A and even B. If finally C manages emerge on the CPE throne, all those who betted on C stock will get Rs 10. Of course, all those who betted on the losing horses would draw a blank. The Prediction Markets, besides vetting our gossip appetites, will add liquidity to the system, and can be a market for legally multiplying some of our wealth! Further, since it is "our own market", the Government of Andhra Pradesh may also lobby with the Government of India for income tax exemption under 80C of Income Tax Act for all capital gains accruing from this legalized gambling operation! And to increase its breadth, the market can even be thrown open to the general investors.

If the Prediction Markets develop sufficient breadth and depth, the day is not too far when the annual transfer list of IAS officers is out in public circulation, much before it is formally announced!! Indeed, one need not be surprised if, like our stock markets driving the economy (rather than the other way round), we find the Prediction Markets leading the transfers!