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Wednesday, Feb. 19, 2003.

Stanford Economists Turn Bookies on Iraq's
Future
By Mark Hulbert

New York Times Service

NEW YORK -- 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 professors arrived at
theirs by using standard econometric analysis and an
unusual derivative that trades at http://www.tradesports.com/, based in
Dublin.

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professors base their unpublished research is indeed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 on
Friday, will pay $10 if Hussein is not Iraq's president
on June 30; otherwise it will pay nothing.

Because the professors assume
that Hussein will not step down voluntarily, they argue
that the contract reflects traders' assessment of the
probability of a war resulting in his ouster. The
contract's 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 to 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
and unconventional 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 Hussein'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 a Harvard
graduate student, is at http://faculty-gsb.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 when 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, more analyses like
this may appear in coming years.

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A series of
articles dedicated to the 10th anniversary of the August 1991
coup.