PANAGIOTIS G. IPEIROTIS, New York University - Leonard N. Stern School of Business
Email: panos@stern.nyu.edu
NIKOLAY ARCHAK, New York University - Leonard N. Stern School of Business
Email: nikolay_archak@yahoo.com

Nowadays, there is a significant experimental evidence of excellent ex-post predictive accuracy in certain types of prediction markets, such as markets for elections. This evidence shows that prediction markets are efficient mechanisms for aggregating information and are more accurate in forecasting events than traditional forecasting methods, such as polls. Interpretation of prediction market prices as probabilities has been extensively studied in the literature, however little attention so far has been given to understanding volatility of prediction market prices.

In this paper, we present a model of a prediction market with a binary payoff on a competitive event involving two parties. In our model, each party has some underlying "abilities'' process that describes the potential to win of the party and evolves as an Ito diffusion. We show that if the prediction market for this event is efficient and accurate, the price of the corresponding contract will also follow a diffusion and its instantaneous volatility is a function of only the current claim price and its time to expiration. We generalize our results to competitive events involving more than two parties and show that volatilities of prediction market contracts for such events are again functions of the current claim prices and the time to expiration, as well as of several additional parameters (ternary correlations of underlying Brownian motions). In the experimental section, we validate our model on a set of InTrade prediction markets and show that it is consistent with observed volatilities of contract returns. To demonstrate practical value of the model we apply it to pricing options on prediction market contracts that were recently introduced by InTrade. Other potential applications of this model include detection of significant market moves, pricing conditional prediction market claims from base claim prices and improving forecast standard errors.

STEVEN L. SCHWARCZ, Duke University - School of Law
Email: schwarcz@law.duke.edu

This short and accessible paper, based on a keynote speech for a law review symposium, addresses how and why the financial crisis occurred and what should be done to avoid future crises. Among other things, the paper explains why neither the making of subprime mortgages nor the originate-and-distribute model pursuant to which these mortgages were monetized was per se evil; why the governmental regulatory structure failed to deter the crisis; and why the governmental bailout plan under the Emergency Economic Stabilization Act is critically needed and where it may be deficient. The paper also explains the difficulties in valuing mortgage-backed securities and in locating the ultimate holders of risk under credit default swaps and the relationship between financial market breakdown and counterparty risk.

PRACHI DEUSKAR, University of Illinois at Urbana, Champaign - Department of Finance
Email: pdeuskar@uiuc.edu
ANURAG GUPTA, Case Western Reserve University - Department of Banking & Finance
Email: axg77@po.cwru.edu
MARTI G. SUBRAHMANYAM, New York University - Department of Finance
Email: MSUBRAHM@STERN.NYU.EDU

This paper examines the effects of liquidity on interest rate option prices. Using daily bid and ask prices of euro (â0AC) interest rate caps and floors, we find that illiquid options trade at higher prices relative to liquid options, controlling for other effects, implying a liquidity discount. This effect is opposite to that found in all studies on other assets such as equities and bonds, but is consistent with the structure of this over-the-counter market and the nature of the demand and supply forces. We also identify a systematic factor that drives changes in the liquidity across option maturities and strike rates. This common liquidity factor is associated with lagged changes in investor perceptions of uncertainty in the equity and fixed income markets.

OGUZHAN KARAKAS, London Business School - Department of Finance
Email: okarakas.phd2005@london.edu

This paper proposes a new approach of inferring the value of voting rights attached to a stock by using options. This method might help solve the problems present in previous studies on the value of control such as endogeneity and data availability. The paper also has implications for option pricing literature. It provides a rational explanation for some of the widely documented violations of put-call parity. Using a sample of 80 US public companies intervened by activist hedge funds from 2002 to the first half of 2006 and their industry- and size-matched firms, I find that the average percentage and probability of lower-bound put-call parity violations are higher for the companies after they are attacked by hedge funds, which is consistent with the predictions of the model.

RAINER BAULE, University of Goettingen (Gottingen)
Email: rbaule@uni-goettingen.de
CHRISTIAN TALLAU, University of Goettingen (Gottingen)
Email: ctallau@uni-goettingen.de

We investigate the price-setting of bonus certificates, a popular type of structured retail products which features an embedded down-and-out put option. Due to the volatility skew, such a product cannot be valued straightforward using classical Black-Scholes analysis. Therefore, we consider the skew-consistent stochastic volatility model of Heston (1993) and analyze its pricing differences to several variants of the Black-Scholes model. Based on a data sample of 808 bonus certificates over a period of 14 months, covering 107,711 quotes, we examine whether the skew is actually priced. Indeed, by comparing model values with actual market prices, we find evidence that issuers take the volatility skew into account. Moreover, when investigating the issuers' margins with the Heston model, we find that margins are of similar size among different issuers, but are larger compared to other structured retail products with embedded plain-vanilla options.

RAJNA GIBSON, University of Zurich - Swiss Banking Institute (ISB)
Email: RGIBSON@ISB.UNIZH.CH
CARSTEN MURAWSKI, University of Melbourne - Department of Finance
Email: carstenm@unimelb.edu.au

In this note we describe some important default risk mitigation mechanisms employed in derivatives markets. We focus on those mitigation mechanisms that differ across contracts traded in today's derivatives markets. We analyze netting, margining, rehypothecation, and central counterparties.