Thursday, 11 May 2017

Betting on HILP Events

Organised betting markets can help to predict future outcomes if they are sufficiently popular, because well-informed people will seek to profit from their inside information and that will affect the market prices.

Less commonly, such markets might also be useful in public policy formation. For example, you could imagine that we might get a reasonable prediction of the effect that a particular well-defined change in land-use policy would have on real estate prices in Auckland, because lots of people have a financial interest in that particular market.

Notice that these markets also need time bounds though. That's why prediction/betting markets always offer time-limited contracts. It is also why they'll be useless in predicting events of the high-impact-low-probability (HILP) type such as:

  • volcanic eruptions in Auckland;
  • your house burning down;
  • workers seizing the means of production; or
  • an excursion of GMOs ruining our environment, productive capacity or export value.  

Notice that is the incidence of such events that is of main interest. Depending on your perspective, each is a disaster or an opportunity. The scale of those effects is large, but otherwise unknown. So even if you have a time-bound view on likelihood, you'll struggle to estimate an expected value, which will make it difficult to price the risk.

Betting markets are likely to be hopeless under these conditions, but fortunately there are market-makers willing to take your money if you want to hedge against such risks. Its called insurance.

No comments:

Post a Comment