Using Markets to Inform Policy: The Case of the Iraq War

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IZA Seminar

Place: Schaumburg-Lippe-Str. 9, 53113 Bonn

Date: 07.12.2004, 12:15 - 13:30

   

Presentation by 

Justin Wolfers (University of Michigan)
   

Abstract:

Market prices incorporate large amounts of information, and our aim in this paper is to demonstrate that prediction markets can help extract this information, prospectively allowing this aggregated expertise to inform policy decisions in real-time. We provide a case study, exploiting data from a market trading in contracts which paid off if Saddam Hussein was removed as leader of Iraq, to learn about financial market participants’ expectations of the consequences of the 2003 Iraq war. We conducted an ex-ante analysis, which we disseminated before the war, finding that a 10 percent increase in the probability of war was accompanied by a $1 increase in spot oil prices that futures markets suggested was expected to dissipate quickly. Equity prices movements implied that the same shock led to a 1˝ percent decline in the S&P 500. Further, the existence of widely-traded options allows us to back out the entire distribution of market expectations of the war’s near-term effects, finding that these large effects reflected a negatively skewed distribution, with a substantial probability of an extremely adverse outcome. The flow of war-related news through our sample explains a large proportion of daily oil and equity price movements. Subsequent analysis suggests that these relationships continued to hold out-of-sample. Our analysis also allows us to characterize which industries and countries were most sensitive to war news, and when the war turned out somewhat better than ex-ante expectations, these sectors recovered, confirming these cross-sectional implications. We highlight the particular features of this case study that make it particularly amenable to this style of policy analysis, and discuss some of the issues in applying this method to other policy contexts.

   
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