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IEM Studies the Predictive Power of Markets

Investors have begun handicapping the 2012 political campaign, using real money on the Iowa Electronic Markets, and the early betting ... er, trading ... narrowly favors President Barack Obama to hang onto the White House while the GOP takes control of the Senate as well as the House.

The IEM, operated by the University of Iowa's Tippie College of Business, lets Internet users purchase "shares" in political propositions: For example, who will win a particular party's presidential nomination? Which party will win the presidency? Who'll be in control of which house of Congress? The Commodity Futures Trading Commission lets the IEM do its thing with real money as an experiment for studying the predictive power of markets.

More than two decades of election-related experimentation suggest that prediction markets can be at least as accurate as traditional opinion polls for forecasting the outcome of elections. Such markets can be applied to other types of forecasting as well—for example, tracking a movie's box-office potential or the likelihood of a flu outbreak.

Here's how the political markets work: Investors bid for shares in a particular proposition—for example, the proposition that a Democrat will be elected to the White House in 2012. If the proposition pays off, the investor receives $1 per share. If the proposition doesn't come through, the investor gets nothing.

When the 2012 presidential-election market opened this month, the Democrat (almost certainly Obama) was favored. Democratic contracts were trading at 57.2 cents a share on July 7, compared with 42.7 cents for the yet-to-be-named Republican candidate. That difference has narrowed in the past couple of days, but Obama is still on top. The IEM's professors say this means Obama is perceived among traders as having a slightly better than even chance of being re-elected.

The trading is a bit more complex when it comes to the prediction market for congressional control, which opened over the weekend: On Monday morning, traders were bidding 44.5 cents for shares that would pay off if the Republicans controlled both the House and the Senate; 21.1 cents for the status quo (Democratic-led Senate, GOP-led House); 18.2 cents for a GOP Senate and a Democratic House; and 17.8 cents for a Democratic sweep.

These trading levels suggest that real-money investors see a GOP sweep as the likeliest outcome of the 2012 congressional elections, although it's not yet perceived as a better-than-even chance.

It's still early in the game: The trading should get more interesting when the IEM starts up its presidential nomination market for the Republicans. Will the markets identify the likely nominee before the pollsters do?  Stay tuned...


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