1580

A prediction market is an exchange where participants can buy and sell contracts whose payos are determined by the outcome of events. The University of Iowa’s Tippie College of Business operates one such exchange, called Iowa Electronic Markets (IEM). For example, it started trading the following contracts based on the outcome of the 2016 US presidential election in November 2014: • DEM16_WTA : $1 if the Democratic Party nominee receives the majority of popular votes cast for the two major parties in the 2016 U.S. Presidential election, $0 otherwise • REP16_WTA : $1 if the Republican Party nominee receives the majority of popular votes cast for the two major parties in the 2016 U.S. Presidential election, $0 otherwise Assume there are only 2 parties and that the winner of the popular vote gets elected president. (1) On 31 July 2015 ( which we will call today ) , you observe that the market price of DEM16_WTA is 58 cents. Also you can invest $1 today in risk-free bonds to give $1.05 by the time election results are determined, what should be the price of REP16_WTA today ? (2) The Republican candidate is friendlier to business, and believes in lowering tax rates. There is a rm which the market believes would be worth $200mn if the Republican candidate wins; and $120mn if the Democratic candidate wins. What should be the rm’s price today ? (3) Suppose you are considering buying a contract, which gives you the right, but not the obligation to buy the rm for $150 mn. What would such a contract be worth today ?