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I written about this topic before but one of the things I find fascinating about finance is how you can use markets for two items to create an “implied market” for a third. This idea is at the root of all the complex financial instruments that caused problems for so many hedge funds recently.

I’ll give you a good example. At InTrade.com, the site where you can trade futures on real world events, you can buy contracts on which candidate will win his or her party’s nomination next year. There’s a separate contract for which candidate will win the presidency.

Let's break out some math, shall we?

If you divide the latter by the former, you get an “electability” contract. For example, according to recent prices, Rudy Giuliani has a 41.5% chance (I'm using the last price) of getting the GOP nomination and an 18.4% of winning the presidency. Soooo...the market believes that if he gets the nomination, he has a 44.34% chance of winning (18.4% divided by 41.5%).

(The only minor flaw is that could include a candidate winning but not getting the nomination, however, I’m content with dismissing that possibility as beyond remote.)

What’s interesting is electability in the general election can have little impact on how well a candidate does in the primaries. Some people, myself included, think that Ronald Reagan would have had a better chance of beating Jimmy Carter in 1976 instead of Gerald Ford, even though Ford beat Reagan for the nomination.

I should add that I don’t place a great deal of faith in these real world futures markets. I simply see them as fun games to enjoy, but not to take too seriously. Also, the markets aren’t very liquid. A minor change could have a big impact on the smaller-priced contracts.

Having said that, here’s a look at some candidates and the market’s take on their electability (sorry Paulites and Edwards fan, your candidates were too low to get a useful meaure).

Candidate………To Get Nomination….To Win............Electability
Hillary..........................59.5...................39.0..................65.55
Obama........................33.0...................17.2..................52.12
Giuliani........................41.5...................18.4..................44.34
Huckabee....................18.6.....................7.2..................38.71
Romney.......................18.8.....................5.9..................31.38

Posted by edelfenbein at December 12, 2007 7:12 AM