Prediction markets: crystal ball for finance? Also known as 'decision support' markets, these online bazaars may hold the key to better forecasts and improved financial controls.

• Author: Ray, Russ
• Position: Global Markets

Financial executives are obviously well versed in forecasting, but they might do well to bone up on predictions--using "prediction" markets in their financial planning and control.

[ILLUSTRATION OMITTED]

Prediction markets--also known as "decision" markets and "decision support" markets--are online markets in which people bet on the future outcomes of every conceivable type of event: political, economic, social, cultural, catastrophic, athletic, and so on, including many financial events. The most famous of these markets is the Iowa Electronic Market (IEM) in which anyone in the world can bet up to $500 in real money on the outcomes of U.S. presidential elections.

According to a study by Credit Suisse First Boston, these markets have "proven to be uncannily accurate" in predicting all types of events. The IEM, for instance, has correctly predicted the outcome of every U.S. presidential election since its inception in 1988. Moreover, this market has also predicted the percentages of votes garnered by U.S. presidential candidates more accurately than any other existing forecasting tool, including election polls and expert opinion. In recent years, the IEM has also conducted betting on U.S. monetary policy and selected stock prices and industry returns.

Hewlett-Packard uses prediction markets to generate unofficial forecasts of its sales. Impressively, HP's prediction markets have forecasted its sales more accurately than the company's own official forecasts, 15 out of 16 times.

Another prediction market, the Hollywood Stock Exchange, predicts opening-weekend movie revenues more accurately than the official forecasts of the movie studios releasing the movies.

Table 1 lists some of the world's major prediction markets, and the types of betting conducted in these markets. All of these markets conduct betting, using either real or artificial money, with real cash prizes often awarded to correct predictors in the markets utilizing artificial money. (The Web addresses of these markets can be easily accessed by placing their names into an online search engine such as Google or Yahoo!.) Table 2 lists some of the many financial forecasts contained in prediction markets.

What's the Secret?

Of course, the logical question regarding these markets is: How and why do they predict so well? The answer is that these markets continually flush out and aggregate information from around the world (including inside information), thus tapping into the collective...