Stanford Economists Turn Bookies on Iraq's = Future


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Wednesday, Feb. 19, = 2003.=20

Stanford Economists Turn Bookies on = Iraq's=20 Future

By Mark = Hulbert=20
New York Times Service

NEW YORK -- Few = people would=20 disagree with the forecast that stocks would = drop if war=20 started tomorrow in Iraq. But two Stanford = economics=20 professors, Eric Zitzewitz and Justin Wolfers, = go=20 further, predicting that the market would drop 5 = percent.

Academics rarely = make precise=20 short-term market predictions. The professors = arrived at=20 theirs by using standard econometric analysis = and an=20 unusual derivative that trades at http://www.tradesports.com/, = based in=20 Dublin.

At this web site, = you can bet=20 on whether Duke will win the NCAA basketball = title,=20 whether "Chicago" will win the Oscar for best = picture or=20 where the Dow Jones industrials will end 2003. = According=20 to John Delaney, the site's chief executive, = most of its=20 active users are traders from Wall Street or = Chicago=20 futures exchanges.

The derivative on = which the=20 professors base their unpublished research is = indeed=20 unconventional: a futures contract on Saddam = Hussein's=20 presidency. The contract, which was trading at = $7.50 on=20 Friday, will pay $10 if Hussein is not Iraq's = president=20 on June 30; otherwise it will pay nothing. =

Because the = professors assume=20 that Hussein will not step down voluntarily, = they argue=20 that the contract reflects traders' assessment = of the=20 probability of a war resulting in his ouster. = The=20 contract's current price suggests that the = market=20 assesses this probability as 75 percent between = now and=20 midyear.

The professors = acknowledge=20 that the contract may seem too bizarre to be the = basis=20 of serious research. They further concede that = its=20 trading volume is low, just over $140,000 over = the last=20 five months. Yet, for a variety of reasons, they = say its=20 price accurately gauges the probability of an = Iraqi war.=20

To counter = concerns about the=20 contract's volume, the professors point out that = it is=20 still higher than that of the Iowa Electronic = Market, a=20 real-money futures exchange administered by the=20 University of Iowa that allows speculating on = the U.S.=20 presidential election. Despite trading volume = that has=20 averaged just $108,000 an election, these Iowa = contracts=20 have had an excellent track record. Their = average=20 forecast error for the popular vote in the last = four=20 presidential contests has been 1.37 percentage = points,=20 about half the average error of nine major = polling=20 organizations, according to a study by four = professors=20 at the university.

Zitzewitz and = Wolfers say=20 they believe that markets in general reflect = more wisdom=20 than any single person can possibly have, and = thus do a=20 better job of assessing probabilities. That = holds true=20 not only for large markets, they say, but also = for small=20 and unconventional ones.

The professors = concede that=20 web-based futures, which are largely = unregulated, could=20 be skewed by someone willing and able to place = sizable=20 buy or sell orders well above or below the = current=20 price. But they doubt that this is the case for = the=20 contract on Hussein's ouster, believing that no = one has=20 an obvious motive to do so.

Once the = professors were=20 satisfied that this contract was a legitimate = basis for=20 research, arriving at their conclusion was=20 straightforward. First, they measured how much = the=20 Standard & Poor's 500 index fell, on = average, when=20 the price of the contract increased, and vice = versa.=20 These measurements let them estimate how low the = S&P=20 500 would drop if the contract approached $10, = which=20 they believe would be likely on the day a war = breaks=20 out. They also calculated how high it would go = if the=20 contract fell to zero, reflecting zero = probability.=20 Their study, conducted with the assistance of a = Harvard=20 graduate student, is at http://faculty-gsb.stanford.edu/zitzewitz/Research/iraq.pdf<= /A>.=20

Their analysis = projects a 20=20 percent difference in the S&P 500's level at = the=20 contract's two price extremes. From this, they = concluded=20 that on the day a war begins, the cumulative = effect of=20 the buildup to war would be a 20 percent drop in = the=20 S&P.

With the $10 = contract trading=20 at $7.50, the professors believe that 75 percent = of the=20 overall 20 percent drop has already occurred. = That=20 implies that when a war begins, the market would = drop no=20 more than an additional 5 percent. If their = forecasts=20 prove accurate, the professors will overcome at = least=20 some of the concerns about the Saddam Hussein = futures=20 contract. In any case, with a proliferation of = such=20 unconventional trading instruments, more = analyses like=20 this may appear in coming = years.

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A = series of=20 articles dedicated to the 10th anniversary of the August = 1991=20 coup.