Wednesday, March 4, 2009

What's The Probability of a Big Market Decline?

Soorry ab out the short post with nothing more than a link in it. I thought I'd saved it as a draft, but goofed (it's a chemo week, and people shouldn;t blog when tired). In any event, check out this piece by Eric Zitzewitz who's guest posting at Freakonomics. He's one of the sharpest guys around on prediction markets (he's also done some nice mutual fund research).

In any event, he usues the intuition developed in Breeden and Litzenberger (1978), who demonstrate how you can create "Arrow-Debreu" securities by comparing the prices of options at adjacent strike prices. For the unitiated (i.e. less nerdy) among you, an AD securitiy pays $1 if a certain event occurrs and zero otherwise. It's basically what the betting contracts at Intrade are. The nice thing about traded AD securities is that the logical price for one is approximately the marginalk trader's probability of the even occurring. So, the prices tell you what "the market's" estimate is of the likelihood of the event).

Zitzewitz uses this intuition to calculate the probability of a large market drop (like the S&P going to 2500 by the ned of next year).

Definitely a cool piece. Read the whole thing here.