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Feb. 23, 2003, 8:12PM

Professors stand by unusual futures contracts
By MARK
HULBERT
New York Times

Few people would disagree with the forecast that stocks would
drop if war started tomorrow in Iraq. But two Stanford economics
professors, Eric Zitzewitz and Justin Wolfers, go further,
predicting that the market would drop 5 percent.

Academics rarely make precise short-term market predictions. The
duo arrived at theirs by using standard econometric analysis and an
unusual derivative that trades at www.tradesports.com, based in
Dublin, Ireland.

At this Web site, you can bet on whether Duke will win the NCAA
basketball title, whether Chicago will win the Oscar for best
picture or where the Dow Jones industrials will end 2003.

According to John Delaney, the site's chief executive, most of
its active users are traders from Wall Street or Chicago futures
exchanges.

The derivative on which the professors base their unpublished
research is indeed unconventional: a futures contract on Saddam
Hussein's presidency. The contract, which was trading at $7.50
recently, will pay $10 if Saddam is not Iraq's president on June 30;
otherwise it will pay nothing.

Because the professors assume that Saddam will not step down,
they argue that the contract reflects traders' assessment of the
probability of a war resulting in his ouster. The current price
suggests that the market assesses this probability as 75 percent
between now and midyear.

The professors acknowledge that the contract may seem too bizarre
to be the basis of serious research. They further concede that its
trading volume is low, just over $140,000 over the last five months.
Yet, for a variety of reasons, they say its price accurately gauges
the probability of an Iraqi war.

To counter concerns about the contract's volume, the professors
point out that it is still higher than that of the Iowa Electronic
Market, a real-money futures exchange administered by the University
of Iowa that allows speculating on the U.S. presidential election.
Despite trading volume that has averaged just $108,000 an election,
these Iowa contracts have had an excellent track record. Their
average forecast error for the popular vote in the last four
presidential contests has been 1.37 percentage points, about half
the average error of nine major polling organizations, according a
study by four professors at the university.

Zitzewitz and Wolfers say they believe that markets in general
reflect more wisdom than any single person can possibly have, and
thus do a better job of assessing probabilities. That holds true not
only for large markets, they say, but also for small ones.

The professors concede that Web-based futures, which are largely
unregulated, could be skewed by someone willing and able to place
sizable buy or sell orders well above or below the current price.
But they doubt that this is the case for the contract on Saddam's
ouster, believing that no one has an obvious motive to do so.

Once the professors were satisfied that this contract was a
legitimate basis for research, arriving at their conclusion was
straightforward. First, they measured how much the Standard &
Poor's 500 index fell, on average, when the price of the contract
increased, and vice versa. These measurements let them estimate how
low the S&P 500 would drop if the contract approached $10, which
they believe would be likely on the day a war breaks out. They also
calculated how high it would go if the contract fell to zero,
reflecting zero probability. Their study, conducted with the
assistance of Andrew Leigh, a Harvard graduate student, is at
facultygsb.stanford.edu/zitzewitz/Research/iraq.pdf.

Their analysis projects a 20 percent difference in the S&P
500's level at the contract's two price extremes. From this, they
concluded that on the day a war begins, the cumulative effect of the
buildup to war would be a 20 percent drop in the S&P.

With the $10 contract trading at $7.50, the professors believe
that 75 percent of the overall 20 percent drop has already occurred.
That implies that if a war begins, the market would drop no more
than an additional 5 percent.

If their forecasts prove accurate, the professors will overcome
at least some of the concerns about the Saddam Hussein futures
contract. In any case, with a proliferation of such unconventional
trading instruments, we should anticipate more analyses like theirs
in coming years.

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