Implied Markets — House Elections

One of the topics in finance I find most fascinating is implied prices. This is when we take the prices of two or more assets and use them to find an “implied” price for another asset.

For example, that’s what the VIX is all about—implied volatility. In the options pricing model, volatility is one of the variables. So what we can do is take the current market price of an index option and work backward to see what number the market has given to the volatility variable.

I’ve noticed that we can also find some implied prices in futures markets on current events listed at Intrade. (Note: This is not — repeat, not — a political post. It’s about implied markets.)

Here’s an example. The current price for the Republicans to win control of Congress is 78.2. That’s a gain of 40 seats. There’s another contract for the Republicans to gain 50 seats. The latest price for that contract is 52.0. (Second note: I don’t take these markets too seriously. I simply see them as entertainment.)

A 78.2% probability translates to +0.779 standard deviations above the mean (that’s NORMSINV in Excel). A 52% probability translates to +0.050 standard deviations above the mean. The difference between those must be 10 seats, so one full implied standard deviation works out to 13.7 seats.

From there we can see that the mean is a gain of 50.7 seats. With the GOP currently holding 178 seats, the market therefore currently expects the GOP to hold 228.7 seats after the election.

I downloaded the historical numbers and here’s what the market’s implied outcome is for the election. The black line is 218 which is a majority. The blue line is the implied mean for the GOP. The red line is one standard deviation above the mean and the green line is one standard deviation below.

Posted by on October 10th, 2010 at 8:39 pm


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