Prediction Markets: Unusually Wide Arbitrage Opportunity, from Igor Z

November 18, 2012 |

I found something interesting and unusual today that I thought would be most appropriate on your site.

An exploitable arbitrage opportunity is developing on the eve of the US Presidential election on some of the more active prediction markets. The following quotes are as of Nov. 5 8:19 PM EDT:

- Intrade sells Obama to win at \$6.76 (meaning you can buy a binary futures contract that pays \$10.00 in the event of an Obama victory for \$6.76). There is about \$50,000 worth of unmatched contracts ready to be sold instantly between \$6.76 and \$7.00.

- Betfair has matched 1.28 odds on Obama (meaning you can win \$1.28 for each dollar bet on Romney). There is about \$60,000 worth of contracts ready to be matched instantly between 1.29 and 1.31.

Assuming you buy \$50,000 of Obama above market on Intrade at an average price of \$6.88, and sell \$58,140 of Obama at an average bet of 1.3 on Betfair, your payoff at expiry (i.e. most likely within 48 hours) will be as follows:

Obama victory: \$(72,674-50,000)+(58,140-75,582) = \$5,232 profit. Romney victory: \$(0-50,000)+(58,140-0)*0.95 = \$5,233 profit.

That's a 4.8% *risk-free* return in two days (note that this is after all transaction costs), which is a conservative estimate since it assumed that you play aggressively and snap up market orders at a significant premium. If playing with more than \$100,000, say \$1M, the return goes down to about 3%, which is still nothing to scoff at considering the time-frame is two days.

The reason that this arbitrage exists is that, unlike more conventional markets, this one is difficult for US citizens and some Europeans to exploit for structural reasons. The IRS, for example, won't allow tax write-offs for losses on either market (in fact the activity altogether 'may' not even technically be legal for US citizens). For this reason, a law-abiding American would wind up paying so much in taxes on the winning side that the net would be negative.

But for someone from a country with less hostile online gambling laws, and a little quantitative know-how to find the right asset mix, there is free money to be extracted from this preposterously inefficient market. If I weren't the law-abiding American I am, I'd be picking it up right now; having to watch others do it because of my country's puritanical laws is more than a little annoying.

Maybe your readers would enjoy this little slap in the face to efficient market theory, even if not in time to make proper use of it. Thanks for your time!

Regards,

Igor Z.

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