Presidential Market Update

Taking out contracts on candidates

Anxious to know who's going to be the Democratic presidential candidate next year? Peering even further into the future, who's going to be prez in 2005? Well, right now, according to the futures markets, it looks like Howard Dean is a shoo-in for the Democratic Presidential nomination and Bush will run away with the national election. At least, that's how the traders over at the Iowa Electronic Markets are bidding.

The IEMs were set up in the 1980s, to test a proposition that market prices aggregate all sorts of information, especially prices in futures markets, and can thus be used to predict outcomes. A quick glance at the current trading makes it apparent that the IEM traders strongly believe Dean will be the nominee. In this case, IEM traders buy and sell contracts on whether or not specific Democratic presidential candidates will win the nomination at the party's convention in Boston this coming July.

The way IEM contracts work is that all contracts for the losing candidates will expire and the winner's contracts will pay off at $1 per share. Right now you can buy a Dean contract for about 60 cents, so if he wins, your profit would be 40 cents per share. Interestingly, the campaign of the Democratic Party establishment's favorite candidate, Wesley Clark, has dropped like a stone: His contracts have fallen by two-thirds from a high of 30 cents per share to around a dime now. Still, Clark is doing better than John Kerry; you can buy a Kerry contract for about a nickel per share.

But what about the general election? How do the Democratic hopefuls stack up against George Bush? Interpreting the presidential futures market is a bit more complicated. To figure out what's going on, I talked with University of Iowa economics professor George Neumann who is one of the principals behind the IEM.

The way to figure out how the traders think various candidates would fare in the general election, according to Neumann, involves a calculation of the probability that a candidate will get the Democratic nomination multiplied by the probability that the traders think that that candidate can defeat Bush. For example, the Bush/Dean contract (BU/DEAN) is a calculation by the traders of the probability that Dean will be the Democratic nominee multiplied by the probability that he will defeat Bush.

First, according to Neumann, you normalize the prices to $1 since the total of all the Democratic candidates' contracts come to only $0.528 right now. That means essentially that you divide Dean's share price ($0.306) by 0.528 which yields 57.95. Then you divide this normalized price by the BU/DEAN contract (0.34), which yields 58.7 percent. The proper interpretation of this figure is that Bush will get 58.7 percent of the two party vote and Dean will get 41.3 percent, according to Neumann. Doing similar calculations yields the IEM market insight that the traders think that Clark would beat Bush by 56 percent to 44 percent and Gephardt would win 57 percent to 43 percent. It seems that the IEM is signaling that the anti-Dean elements of the Democratic Party establishment are right.

So there you have it—Dean is the Democratic nominee and Bush is president for four more years.

Who knows? Perhaps one day we will have robust political futures markets where you can hedge against bad policy outcomes—say you fear that Dean will win, so you buy contracts so that you can pay the higher taxes he promises to impose. It could happen.

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