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Using Markets to Inform Policy: The Case of the Iraq War

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  • JUSTIN WOLFERS
  • ERIC ZITZEWITZ

Abstract

Financial market-based analysis of the expected effects of policy changes has traditionally been exclusively retrospective. In this paper, we demonstrate by example how prediction markets make it possible to use markets to prospectively estimate policy effects. We exploit data from a market trading in contracts tied to the ouster of Saddam Hussein as leader of Iraq to learn about financial market participants' expectations of the consequences of the 2003 Iraq war. We conducted an "ex-ante" analysis, which we disseminated before the war, finding that a 10% increase in the probability of war was accompanied by a $1 increase in spot oil prices that futures markets suggested was expected to dissipate quickly. Equity price movements implied that the same shock led to a 1.5% decline in the S&P 500. Further, the existence of widely-traded equity index options allows us to back out the entire distribution of market expectations of the war's near-term effects, finding that these large effects reflected a negatively skewed distribution, with a substantial probability of an extremely adverse outcome. The flow of war-related news through our sample explains a large proportion of daily oil and equity price movements. Subsequent analysis suggests that these relationships continued to hold out of sample. Our analysis also allows us to characterize which industries and countries were most sensitive to war news and when the immediate consequences of the war were better than "ex-ante" expectations, these sectors recovered, confirming these cross-sectional implications. We highlight the features of this case study that make it particularly amenable to this style of policy analysis and discuss some of the issues in applying this method to other policy contexts. Copyright (c) The London School of Economics and Political Science 2008.

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Bibliographic Info

Article provided by London School of Economics and Political Science in its journal Economica.

Volume (Year): 76 (2009)
Issue (Month): 302 (04)
Pages: 225-250

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Handle: RePEc:bla:econom:v:76:y:2009:i:302:p:225-250

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Cited by:
  1. Snowberg, Erik & Wolfers, Justin & Zitzewitz, Eric, 2011. "How Prediction Markets Can Save Event Studies," CEPR Discussion Papers 8351, C.E.P.R. Discussion Papers.
  2. Wolfers, Justin & Zitzewitz, Eric, 2006. "Prediction Markets in Theory and Practice," IZA Discussion Papers 1991, Institute for the Study of Labor (IZA).
  3. Daniel Waldenstrom & Bruno S. Frey, 2006. "Using Markets to Measure Pre-War Threat Assessments: The Nordic Countries facing World War II," CREMA Working Paper Series 2006-27, Center for Research in Economics, Management and the Arts (CREMA).
  4. Charles, Amélie & Darné, Olivier, 2014. "Large shocks in the volatility of the Dow Jones Industrial Average index: 1928–2013," Journal of Banking & Finance, Elsevier, vol. 43(C), pages 188-199.
  5. Bruno S. Frey & Daniel Waldenstrom, 2007. "Using Financial Markets to Analyze History: The Case of the Second World War," CREMA Working Paper Series 2007-19, Center for Research in Economics, Management and the Arts (CREMA).
  6. Ray C. Fair, 2004. "Predicting Electoral College Victory Probabilities from State Probability Data," Cowles Foundation Discussion Papers 1496, Cowles Foundation for Research in Economics, Yale University.
  7. Berkman, Henk & Jacobsen, Ben & Lee, John B., 2011. "Time-varying rare disaster risk and stock returns," Journal of Financial Economics, Elsevier, vol. 101(2), pages 313-332, August.
  8. Ray C. Fair, 2006. "Interpreting the Predictive Uncertainty of Elections," Cowles Foundation Discussion Papers 1579, Cowles Foundation for Research in Economics, Yale University, revised May 2007.
  9. He, Yinghua & Nielsson, Ulf & Wang, Yonglei, 2014. "The Cost of Political Tension: An Anatomy," TSE Working Papers 14-484, Toulouse School of Economics (TSE).
  10. Edoardo Gaffeo, 2013. "Using information markets in grantmaking. An assessment of the issues involved and an application to Italian banking foundations," DEM Discussion Papers 2013/08, Department of Economics and Management.
  11. Massimo Guidolin & Eliana La Ferrara, 2010. "The economic effects of violent conflict: Evidence from asset market reactions," Journal of Peace Research, Peace Research Institute Oslo, vol. 47(6), pages 671-684, November.
  12. Choudhry, Taufiq, 2010. "World War II events and the Dow Jones industrial index," Journal of Banking & Finance, Elsevier, vol. 34(5), pages 1022-1031, May.
  13. Ray C. Fair, 2006. "Interpreting the Predictive Uncertainty of Presidential Elections," Levine's Bibliography 321307000000000427, UCLA Department of Economics.

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