Election stock markets (also referred to as election prediction markets) are financial markets in which the ultimate values of the contracts being traded are based on the outcome of elections. Participants invest their own funds, buy and sell listed contracts, earn profits and bear the risk of losing money. Election stock markets function like other futures exchanges, such as commodity exchanges for the future delivery of grain, livestock, or precious metals.
The main purpose of an election stock market is to predict the election outcome, such as the share of the popular vote or share of seats each political party receives in a legislature or parliament. Efficient markets are very good at reflecting all available information, often reflecting information faster than opinion polls, which take several days to complete and process. Traders also have a strong financial incentive to reflect their true opinion about the election outcome regardless of their political preferences.
Election stock markets are also used for research and teaching purposes. Researchers can study trader behavior and market operations. Election stock markets also teach participants the fundamentals of trading, such as how to take a long or a short position. A list of related academic research papers appears below.
Examples of election stock markets
In North America, two universities have been operating election stock markets for over a decade. The University of Iowa's Tippie College of Business has been operating the Iowa Electronic Markets . The Iowa markets primarily track presidential and congressional elections. In Canada, the University of British Columbia's Sauder School of Business has been operating the UBC Election Stock Market. The UBC markets track federal and provincial elections in Canada. The Iowa and UBC markets are non-profit operations for research purposes. These markets do not charge commissions or transaction fees. Investments are typically limited to US$500 or CAD 1,000.
Privately run prediction markets have also emerged in recent years. Unlike their university counterparts, commercial prediction markets charge fees or commissions to cover their operating costs. Commercial markets may charge fees per transaction or commissions on net profits, and fees per transaction may be differentiated for price takers (those placing a market order) and price makers (those placing a limit order). Early examples of commercial prediction markets include the now defunct Intrade Prediction Markets and The Washington Stock Exchange; both tracked predictions for a broad set of political events. Commercial prediction markets claim that they attract more investment and generate more trading volume than their academic counterparts as they don't limit a trader's capital investment. The prediction accuracy of commercial and academic election stock markets is an area of active research (see below).
How do election stock markets work?
Types of markets
There are two basic types of election stock markets. The first type is a winner-takes-all market in which only one contract pays a fixed sum, typically $1, and all other contracts pay $0. Examples of this type of winner-takes-all market include a referendum outcome (yes or no), one of several parties winning an absolute majority, or one of several parties winning a plurality.
The other type of election stock market is a proportional share market where the payout of several contracts is determined by percentage proportions of a particular outcome, multiplied by a fixed sum that is typically $1. Two examples of such a market include a seats share market, where payouts are determined by the percentage share of seats that a particular party gains in a parliament, or a popular vote share market, where payouts are determined by the percentage share of a party's popular vote.
The common principle across different types of election stock markets is that the payouts for a "unit portfolio" of contracts must add up to a fixed amount, typically $1.
Creating contracts
Contracts are put into circulation through the purchase of a unit portfolio. A trader purchases a set of all contracts in a particular market worth $1. Consider an election in which three parties compete, a Red Party, a Blue Party, and a Green Party. The share of popular votes for each party must sum to 100% by definition, so holding on to one contract for each of the three parties will always be worth $1 no matter what the election outcome. Buying unit portfolios allows trader to take a short position by selling contracts that they think are overvalued.