February 16, 2003

There's a Futures Contract for Everything (Even Iraq's
Fate)
By MARK HULBERT

EW 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 www.tradesports.com, based in Dublin. At
this Web site, you can bet on whether Duke will win the N.C.A.A.
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The derivative on which the professors base their unpublished research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 Mr. Hussein is not Iraq's president on June 30; otherwise it will
pay nothing. Because the professors assume that Mr. Hussein won't 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 American 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.

Professors 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 Mr. 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 Andrew Leigh, a Harvard graduate student, is at
http://faculty-gsb.stanford.edu
/zitzewitz/Research/iraq.pdf.

HEIR 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,
we should anticipate more analyses like theirs in coming
years.

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