## [Computational Complexity] Markets and Polls

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• A couple of weeks ago a strange thing happened on our electoral markets map. California turned red for a couple of hours. A few days later Michigan turned red
Message 1 of 1 , Sep 25, 2008
A couple of weeks ago a strange thing happened on our electoral markets map. California turned red for a couple of hours. A few days later Michigan turned red as well. Neither of these states are about to vote republican, rather there were odd trades of Obama at a very low price in California and McCain at a high price in Michigan. Since we used the closing price the states were colored wrong until another trade occured.

So we adjusted our algorithm so that if the closing price is lower than the bid price (the price someone is willing to pay) we use the bid price instead. Also if the closing price is higher than the ask price (the price someone is willing to sell) we use the ask price. That seems to avoid the problems of rouge trades.

Which brings me to a controversial post at fivethirtyeight.com, a site that makes predictions based on poll numbers. Nate Silver notes that the prediction of Obama of the markets to win the presidency (about 58%) is much lower than his site's prediction (about 72%). Silver suggests the disparity is because of a rouge trader or traders that seem to be driving the price down and even buying Hillary stock.

I don't buy it. There is quite a bit of volume on these securities and the prices on Obama should bounce back quickly and in fact it does. The rouge trader cannot explain a difference of 14 points. The Hillary factor can be explained by the long-shot bias (people overweigh low probability events). The markets suggest that the probability that Hillary is president is about the same as McCain winning Illinois which sounds about right (even if they are both too high at around 4%).

I have a different theory: The race is tighter than the Silver analysis suggests. The polls can give you numbers about each state but not the correlation between them. Silver gives an explanation of how he handles the correlations in his simulations:

Our simulation accounts for this tendency by applying a similarity matrix, which evaluates the demographic relationships between different states by of a nearest-neighbor analysis as described here. Our process recognizes, for instance, that as the polling in Ohio moves, the polling in a similar state like Michigan is liable to move in the same direction. On the other hand, there may be little relationship between the polling movement in Ohio and that in a dissimilar state like New Mexico.
Silver admits he has little data to back up this claim. I believe the correlations are much tighter—that most of the states might move in the same direction depending on some future event or ad or gaffe or performance on the yet-to-be-held debates, that there is high future correlation even between Ohio and New Mexico.

The swing states are typically highly correlated and if the four states running about 50% (Nevada, Ohio, Virginia and New Hampshire) all go to McCain then the Electoral college ties and it would just take one other state (like New Mexico) to push it over.

The analysis of each state can be done well with polls and historical data and the market prices and polls for the individual states do not differ that much. But understanding the correlations between states is more guesswork and I trust the wisdom of the crowds over the wisdom of the one.

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Posted By Lance to Computational Complexity at 9/25/2008 06:42:00 AM

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