Good point about how people aren’t routinely taught how things work. This is as true for important principles of business and finance as it is for plumbing. If more people had basic knowledge about this stuff it would be difficult for politicians and media to scapegoat markets, or valuable market tools such as derivatives, for problems caused by institutional management failures and corruption.
Markets and Trading
It’s Called Replacement Pricing, D*mmit!
This really chaps my hide.
I’m watching news stories about hurricane Ike and the subsequent rise in gas prices in parts of the country far distant from the storms. Reporters and politicians mumbled confusedly about how prices could be going up already.
I’ll say it one more time for those who can’t be bothered to actually ask someone who owns a gas station. Gas stations set prices for the gas they sell today based on the wholesale price of the gas they will have to buy to replace it. Get it? The price you pay for a gallon today is the cost of the gallon the station will have buy to replace the one you just bought.
Gas stations sell gas at or near cost, so if they did not use replacement pricing any sudden spike in gas prices would shut them down and you couldn’t get any gas. I simply do not know why our public and private talking heads cannot understand and communicate this simple fact.
[update (9.13.2008.9:55am): More on gas pricing via Instapundit]
Communal Memory and Financial Markets
Via Instapundit, an interesting NYT column about how quickly, after a natural disaster, people start to over-discount the risks of future disasters, especially in advanced societies:
Communal memory of rare disasters is worse in more developed societies because knowledge now is passed on in schools, movies or the internet leaving no time for oral history or reliance on the elders to learn about the world.
Something similar to the quick-forgetting phenomenon happens in financial markets. In every market, some players prosper for a while by following trading strategies that tend to be highly profitable from day to day but that are almost guaranteed to be big long-term losers: martingales, naked out-of-the-money option writing and other short-gamma strategies. Every time there is a big market event, a lot of these players suffer large losses and go out of business. They move on to other businesses (I assume) and are no longer around to warn market newcomers to avoid the kind of risky, short-term-profitable strategies that they themselves once followed. So there is a constant stream of new traders who enter the markets and rediscover risk.
This is an oversimplification, since the better traders, by definition, somehow learn how to stay in the game for the long term. But the behavioral parallels between market traders and people who rebuild villages in flood zones — and countries that seek to appease their enemies — seem clear. The common element is lack of an adequate inter-generational feedback mechanism. I doubt that there is a remedy for this pattern of human behavior (I wouldn’t characterize it as a “problem” any more than I would say that rain is a weather problem) other than for people to study history more.
The Government Wants Your Opinion on Prediction-Markets Regulation
The US Commodity Futures Trading Commission (CFTC) is soliciting public comment on the regulatory treatment of event (prediction) markets and prediction-market exchanges. These markets allow participants to take positions, in some cases with real-money consequences, on the odds of various events such as the election of particular political candidates, the frequency of hurricanes, and trial verdicts. (Intrade, whose quote board appears on the left margin of this blog, and of whom we are an affiliate, is an outstanding example of a prediction-markets exchange.) There is significant evidence that such markets provide the best available probabilities on the occurrence of many kinds of events and thus benefit all of us.
The central concern regarding prediction markets in the USA is their legal and regulatory classification. Currently it appears that some types of prediction markets are forbidden as “Internet gambling” (thank Congress), and there is uncertainty about others. Executives of offshore prediction-market exchanges have been harassed legally, and on at least one occasion arrested when they passed through this country. The uncertain US legal climate is chilling development of this beneficial industry, and there is interest from the industry in gaining for itself a regulatory safe-harbor similar to that enjoyed by established futures and options exchanges. Aside from the obvious libertarian argument for allowing business between consenting adults, I see no downside to the public and, as I suggested, the potential benefits are large.
The CFTC proposal and instructions for comment (you may comment by email) are HERE.
The CTFC is asking for comment on what its regulatory stance toward this nascent industry should be. IMO, Tom Bell’s proposal, posted at the indispensable Midas Oracle, is a good start. Tom will submit his response to the CFTC in petition form. If you want to sign on, contact him at [tbell at chapman dot edu] before noon PST on July 6. (N.B. Please see his post for complete details before you contact him.) I am going to sign Tom’s petition and I recommend that you do too, unless you have a better proposal — in which case please post it in the comments here or email it to me.
Unfortunately, comments must be received by the CFTC by July 7, which leaves little time for anything other than email unless you are in DC. But better to make your opinion known on short notice, as I will, than not at all.
The prediction-markets industry is a worthwhile cause with prominent enemies including Congressional anti-gambling activists, and significant parts of the established futures industry (nobody likes competition). It would be a great loss if this worthwhile new industry continued to be crippled by outdated regulatory practices.
(For more background, I strongly recommend this post by Chris Masse at Midas Oracle. Ignore the stuff about Wolfowitz, just scroll down to the “BACKGROUND INFO” links and start clicking.)
Quote of the Day
Blaming speculators for inflation is like blaming surfers for tsunamis.