From: ichudov@algebra.com (Igor Chudov @ home)
Date: Sun, 3 Nov 1996 21:43:46 -0800 (PST)
To: asgaard@Cor.sos.sll.se (Asgaard)
Subject: Political Derivative Securities
In-Reply-To: <Pine.HPP.3.91.961104015509.23465A-100000@cor.sos.sll.se>
Message-ID: <199611040446.WAA16999@manifold.algebra.com>
MIME-Version: 1.0
Content-Type: text


Asgaard wrote:
> 
> On Sat, 2 Nov 1996 ichudov@algebra.com wrote:
> 
> > >         | Clinton | Not currently offered by either |
> > >         | Dole    |     6:1        |     10:1       |
> > 
> > Whew! They are wide open for arbitrage! Suppose that at Ladbroke I sell

I meant "I go to Ladbroke and sell it to people hanging out there" 
-- see below.

> > an obligation to pay $6 if Dole wins (they are apparently valuing it for
> > this much), collecting $1. At the same time, to hedge my exposure, I go
> > to "William Hill", and purchase their obligation to pay _me_ $10 if Bob
> > Dole wins, paying the $1 bill that I just got at Ladbroke's.
> 
> The problem is that Ladbroke won't take your offer, they don't
> work that way. If they wanted to insure against a Dole victory
> they would place some of the money they got from betters on Dole
> at William Hill, at 10:1, instead of taking your offer at 6:1.
> But probably they get too few bets on Dole to bother with insurance;
> they do take risks. Another way of insuring themselves would have
> been to offer 11/10 or something on Clinton but obviously they
> don't feel they have to do that.

Seems like you see the problem yourself: obviously Ladbroke gets a free
ride since they can simply insure themselves by placing offsetting
bets at William Hill.

My argument, however, does not require one of the houses (Ladbroke's)
accepts the reverse bets (which pay me money of Clinton wins). My
argument runs like this: There are persons hanging around Landbroke who
apparently think that if they give Landbroke $1 in return for the
promise to pay them $6 if Dole wins, they get a good deal.

It is these people together with "William Hill" whom we exploit.

What I do is the following: I go to the Ladbroke's and offer to pay the
gamblers not $6, but $6.01 if Dole wins. Being somewhat rational, these
gamblers see a better deal than Ladbroke's offers, and give me their $1
bills. This is very simple.

I take their $1 bills and run to "William Hill", where I take another
side of the bet. 

If Clinton wins, I get nothing and lose nothing. If Dole wins, I gain
$3.99 on every bet that these suckers agreed to make with me.

That was the essense of arbitrage that I propose.

Again, as I said, there is a way to make sure money on this 
situation, that is, to make money even if Klinton wins.

The arbitrage strategy is the following: as before, I go to the
Ladbroke's and offer to pay them not $6, but $6.01 if Dole wins.
I take their $1 bills and go to "William Hill". I buy, however, LESS
bets than dollar bills that I received. In particular, I buy 
$6.01 / $10.00 bets for each dollar that I receive.

The remaining money $1(1-6.01/10) I simply take to my bank. This money
is mine: if Clinton wins, nobody gets anything; if Dole wins, I get
exactly enough money from "William Hill" to pay off my debts to the
gamblers at Ladbroke's.

Of course, if gamblers could compare prices and choose gambling houses
easily, no one would ever buy these bets from Ladbroke (unless they are
crazy).

This situation means that there is some market imperfection that 
does not allow arbitrage. It is not clear, though, what this
imperfection is.

It got me thinking about the following: someone oughtta make money by
selling "political derivative securities". For example, a bank could
issue Pro-Dole option contracts with a promise to pay the holder of the
contract $1000 if Bob Dole wins elections. These contracts could be
traded at, for example, CBOE, just as any other standard derivative
securities.

I see no real difference between a stock serving as an underlying
security, and an outcome of a political event serving as an underlying
security. There can be legitimate reasons for businesses to hold these
"political derivative securities". For example, businesses may hold them
to hedge their exposure to predictable changes in interest rates that
depend on the election outcomes.

Has this been done?

        - Igor.