February 16, 2006

Politics and the Markets

Prediction Markets By: ams

Donald Luskin
noticed a stock market anomaly
, and when he looked for
explanations, he found a possibility on TradeSports. On January 20th,
the stock market had its biggest one-day drop in three years, but
recovered completely over the next few days. Luskin wondered what had
caused the short term spike, and didn’t find any reasonable
explanations in the financial press. When he looked on TradeSports,
he found that the markets on whether the Republicans will keep their
majority in the House of Represenatives this fall also had a one-day
drop.

Luskin suggests that the increased chances of a change in control of
the congress, whatever the cause of that, was probably enough to spook
the market. Since the GOP House contracts recovered to their former
levels within a few days, he concludes that that scare receded, and
that would explain the market’s short term slump and recovery.

Unfortunately for his thesis, Luskin left something out. TradeSports
has separate markets for the Republican’s control of the House and the
Senate, and the two markets moved strongly in opposite directions.
Now it may be that you can explain this away by noting that a change
from 69% to 63% in the chances for the Republicans to retain the House
is much more significant than a change from 79% to 89% in their
chances for retaining control of the Senate, since the former says
there is doubt that they will retain control of both, while the latter
says it’s still likely they’ll continue to control the Senate.

While Luskin only handwaved about the relationship between the stock
market and politicians’ expected behavior, a paper by

Wolfers and Zitzewitz
found significant correlations between the
financial markets and TradeSports’ markets on the chances for war and
for Saddam’s capture. Seems like it shouldn’t be too hard to do a
similar study now that there are explicit markets on control of the
congress.

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