Friday, July 15, 2005

Random Economics Thought of the Day...

Futures markets serve a valuable function: they facilitate the hedging of costs against an uncertain future, and they lubricate the market against a variety of threats via arbitrage. The Iowa Electronic Markets took an interesting spin on this concept in the last election: they created real-money futures on the winners of the 2004 US Presidential Election. At first blush this may seem like a distortion of the intended purpose of futures markets--this was, after all, just speculation. There were not uncertain costs to hedge against. It was intended to illustrate the ability of "the market" to integrate disparate information and fix a price more accurately than any one individual--in this case the political polls. But in reality it seemed to me more like betting on a fight in Vegas.

Until, of course, my random Friday-afternoon economics pondering...

Political decisions do, of course, reflect uncertain economic costs. So this kind of futures market may provide a very valuable hedge service. Take a few examples:

- If you're a were a Bush staffer, it would have made sense to buy a few "Kerry '04" call options. Bush wins, you keep your job and salary. Kerry wins, you lose your job and collect the small windfall on your options to tide you over until you can find another job.

- You're a US manufacturer concerned that the US will adopt the Kyoto protocol in 2008. Hedge your potential future costs by buying an option on this proposal.

Are these really "options", or are they just "bets"? It doesn't really matter if you call these positions "bets" or "options", or if they work on "odds" or "price"--they can serve the same valid economic purpose.

Most people bet on what they want to have happen. Hedging requires that one does the opposite. Would it make economic sense for a fighter to place a hedge bet on his opponent? Would it make economic sense for a football coach to place a bet that his own team will be below .500 next season? Both cases illustrate the capacity for "unorthodox hedges". Southwest Airlines certainly profited from one such hedge--they are 100% hedged on fuel costs through 2006, and as a result they are the only profitable airline.

What about the potential for arbitrage in such unconventional markets?

End of random thought.

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