The Derivatives Of Politics

Wall Street is betting on Washington, literally.

In its ongoing "What Went Wrong" series, the Big Think interviewed Nobel Prize-winning economist Vernon Smith last week. His responses provided a slew of interesting perspectives on the financial crisis and reform effort. But I wanted to specifically note what he thought to be the future of derivatives: political futures. Whether Professor Smith realizes it or not, the future is already here.

Smith was asked what he believed "might be the next application of derivatives and how might this change the way we live." He responded:

So far as new applications of derivatives markets I think one possibility is we may see more people making, creating derivatives markets, betting markets on policy, public policy outcomes. We've already seen that with regard to the Federal Reserve. There is a market now in which people are able to make, take positions on the likelihood of a change in the Federal Reserve Bank policy at their next meeting of the Federal Open Market Committee, so and these markets are concerned with the question of what the Federal Reserve Bank rate will be set at. So I think we may very well see more of these kinds of markets and this could very well provide some indication of how the participants in these markets evaluate some of the policy proposals that governments are making.

In fact, the derivatives market has already begun to bet on political outcomes. I am familiar with several companies that already engage in this business, the most well-known of which is probably Intrade. For example, right now I can go to Intrade and buy a futures contract based on the outcome of the Massachusetts Special Election to replace Senator Ted Kennedy. Here's how it would work:

If Intrade says that I can buy a derivative predicting that a Democrat will win the seat (presumably Martha Coakley) for 60 (indicating that this derivatives market predicts a 60% chance of a Democrat winning), then I can buy a derivative indicating that outcome for $6. After the election, if Coakley wins, I get $4. If she loses, then I lose my entire investment.

Of course, like any other liquid derivative, I can also sell the security before the election. Imagine that I had bought the derivative on Friday. But then, a big scandal had struck Coakley this weekend. Her probability of winning subsequently dropped from 60% to 20%. I might not think she has a chance to win at this point, so I sell the derivative to someone today who still thinks she has a chance, but a smaller chance, for $2. I would have lost $4 of my initial investment.

What's the difference between this and, say, betting on sports? Very little. But what's the difference sports betting and a derivative based on a company's stock's future price? Again, very little. But with financial derivatives, the claim is that there's a useful business purpose for most derivatives. For example, let's say I own company A and do a lot of business with company B. If I buy a derivative that bets against company B, then I could be hedging the profits I expect due to the relationship I have with it. If company B fails, and I lose those potential profits, then at least I'll get some money from my derivative position to cover my losses. Compare that to sports, where the outcome probably has far less of a practical utility, usually.

But do political derivatives have real usefulness? As Washington becomes more and more involved in business and finance, I'd say that they certainly could. Let's consider an example.

Let's say that I'm General Electric and it's 2008 -- before the election. I'm trying to decide whether to invest in some new carbon capture technology. Clearly, if the Democrats win, cap and trade has a much better probability of passing, and I would profit handsomely from this investment. What if I could hedge my investment by purchasing a derivative that paid out with a Republican win? Now, if the Republicans win, cap and trade never happens, and the investment turns out to be a loser, but my net loss will be smaller thanks to my hedge. The derivative I purchased will have covered some or all of my investment's loss.

You can bemoan the fact that these derivatives could be so useful, due to how entrenched politics has become in business, but that's the reality we live. So I agree with Smith: political outcome-based derivatives are likely to become much more important as the relationship between business and politics becomes cozier and cozier. In fact, as companies like Intrade show, that future isn't too far off.