How Prices are Set in a Market Economy

Introduction to Contingent Contracts and What Their Prices Mean

Traders at trading desk
Traders at trading desk. Getty Images/Tetra Images/Brand X Pictures

Markets, when they operate efficiently, can provide a great deal of information on the beliefs of the people who participate in that market. Prices, and changes in prices, convey a lot of information on what traders think is currently happening and what they believe will happen in the future. To see how this works, we'll look the at the pricing of a simple asset known as a contingent contract.

 

Introduction to Contingent Contracts

A contingent contract in finance generally refers to a contract in which the amount of money one agent pays to another in the future will differ depending on the realization of some future event.

A simple example of a contingent contract is a contract that gives the bearer of that contract nothing if it rains next Thursday or, alternatively, one dollar if it does not rain. While this may feel like a silly example, essentially betting on the weather, contracts that make these kinds of bets are more common than you might think. For instance, a farmer's crop can depend quite heavily or whether or not it rains. If it does rain, he has a healthy crop that he can sell on the market. Conversely, if it does not rain, the crop will likely suffer and the farmer will less to sell. But the farmer can minimize this risk by buying contingent contracts. For example, if the farmer buys such contingent contracts and it does not rain, his crop may be worthless but he will receive $1 for each contract he holds. Of course, if it does rain, his crop will be valuable, but he'll have paid money for contingent contracts which are now worthless the investment in which will count against his crop's profit.

If the farmer buys enough of these contracts, he can ensure that he receives the same amount of money no matter what the weather does. This sort of risk-minimization is known as and is used quite frequently, particularly in finance.

 

Interpreting Contingent Contracts

From an informational standpoint, contingent contracts (also known as "contingent claims") can be extremely helpful because they can reveal what the market thinks will happen based upon participant's behavior.

 Suppose our $1 if it doesn't rain and $0 if it does rain contingent contract is selling for 70 cents. Such a price would imply that the market believes that there is a 70% chance it will not rain and a 30% chance that it will. Put is another way, this price reflects that belief that 70% of the time the contingent contract will be worth $1 and 30% of the time the contingent contract will be worth nothing.

Now suppose a number of people in the "rain" market receive a new piece of information such as satellite images, and now hold the belief that the chance of it not raining on Thursday is actually 90%. This new information should motivate them to value the example contract at 90 cents, but the price is currently at 70 cents. Smart investors would recognize this undervaluation and, as a result, would buy these contingent contracts at 70 cents expecting to make a 20 cent profit per contract on average. But the increase in demand for these contracts will cause the price to rise, and if enough people in the market believed the chance of no precipitation is 90%, we'd expect to see the value of the contingent contract to eventually rise to meet the belief at 90 cents.

To see a good example of market price changes and contingent contracts, we'll look at the world of baseball on Page 2.

Contingent Contracts in Sports Gambling

While most often used for a means of investing in the market, contingent contracts have also been used as a form of entertainment. For instance, an Irish-based website named TradeSports.com allows people to gamble on sports events using contingent contracts as a basis. You can buy contracts on all sorts of events, from who will win tomorrow's Blue Jays vs. Red Sox game to who will win the next Superbowl.

These contingent contracts work in a similar fashion as our rain example on the previous page. Suppose you buy a $1 Blue Jay contingent contract. If the Blue Jays win, you get $1, but if they do not win, the contract is worth $0 and pays nothing. The market price for such a contract, just as in the rain example, can be interpreted to understand what the market thinks will happen. Using a real-world sports example, the last trade price of the Tiger Woods contract for the 2003 British Open as of July 16, 2003 was 22 cents, meaning that on that date (1 day before the start of the tournament), the market believed that Tiger had a 22% chance of winning the tournament. It just so happens that Ben Curtis won the championship that with Tiger Woods placing T4. But that is not to imply that the market is always right.

 

The 2003 Major League Baseball All-Star Game

Let's take a look at the 2003 Major League Baseball All-Star Game as another example of contingent contracts in play.

The All-Start game was expected to be a match between two equally capable teams. Before the game began, the price of the American League contract had been hovering around 50 cents, so it could be deduced that the market believed that the American League seemed equally as likely to win the game as the National League team with the contract price suggesting the belief in a 50/50 chance.

When the game began, the price was still around 50 cents, as investors had not learned any new information that would cause them to change their beliefs about the outcome of the game. After an uneventful inning and a half, the American League started to make some noise. With two out in the inning, American Leaguer Edgar Martinez was hit by a pitch, then teammate Hideki Matsui hit a single, putting two men on base for Troy Glaus. Although there were two out, it looked like the American side had a chance to score some runs, which would obviously improve their chances of winning the game. During that inning, the price of the American League contract rose from 48 cents to 55 cents as investors felt that having two men on base and two outs in a tie game in the 2nd inning raised the American League's chances to win to 55%. Glaus struck out swinging and the price of the contingent contract fell almost immediately back to 50 cents. A piece of new information (the Glaus strikeout) caused the price of the contingent contract to fall 10%, despite the fact that the game was nowhere near completion.

The National League side was unable to do much against American League pitcher Roger Clemens, but a single by Ichiro Suzuki, a wild pitch by National League pitcher Randy Wolf, and a single by Carlos Delgado put the American League up 1-0 and the price of the contingent contract back up to around 65 cents.

With Delgado on first and two outs, Alex Rodriguez grounded out to third base, and the price of the contingent contract slid to 60 cents.

Everything fell apart for the American League during the 5th inning. The first National League batter of the 5th inning got to first base on a walk, and the second, Todd Helton, made the score 2-0 on a home run. After the third batter of the inning, Scott Rolen, hit a single, the price of the contingent contract was down to 33 cents. The next two batters for the National League got out sending the price up to 38 cents, but a double by Andrew Jones and a single by Albert Pujols sent the score to 5-1 and the price of the contract to around 16 cents. The price did not seem to recover any after Barry Bonds struck out.

By the bottom of the 6th inning, the market believed that the American Leauge only had a 10% chance of winning.

A two-run home run by Garret Anderson caused the price to double to 20 cents, but the price hike was short lived as a 7th inning home run by Andruw Jones for the National League sent the price back down to 10 cents. Although the score was only 6-3, Fox, the network carrying the game, said that the American League did not stand much of a chance of winning since the National League's closers were unbeatable. Even a home run by Jason Giambi sending the score to 6-4 only moved up the contingent contract price to 15 cents.

Be sure to continue to page 3 for the conclusion of the game and its impact on contract prices.

The Conclusion of the 2003 MLB All-Star Game

Things were looking pretty dire for the American League as they had to face Eric Gagne in the 8th inning and John Smoltz in the 9th inning while they had a two run deficit. With one out in the 8th, Garret Anderson hit a double, sending the contingent contract price up to 22 cents. Earlier in the game a hit that did not score a run would not have had much effect on the price, but since it was late in the game and the score was close, investors knew that even a small change in circumstances could change the outcome.

As a result, the price changes became more dramatic near the end of the game. A ground-out by Carl Everett sent the price down to 19 cents, but a run-scoring double by Vernon Wells sent the game to 6-5 and caused the price to rise to 52 cents. Although the American League was still losing, investors believed that with a runner on 2nd and two outs, they were still slightly more likely to win the game than the National League side. Hank Blalock, the next hitter, hit a towering home run which brought American League into a 7-6 lead very late in the game and caused the price to escalate all the way to 85 cents.

In a matter of 10 minutes, the value of the contingent contract had increased eight-fold, and investors who had bought at 10 cents suddenly held a very valuable asset. With the 8th inning over, the American League needed just three more outs to win the game. They would get those three outs and not score any runs.

During the 9th inning, the price of the contract rose from 85 cents to 1 dollar, the price it eventually paid to the end holders.

 

This Experience is Not Uncommon

This phenomenon of the extremely responsive real-time price of contingent contracts is not limited to 2003 All-Star game. In fact, even seemingly less relevant information can influence investor's beliefs about outcomes and by extension contract prices.

 

For instance, a day before the All-Star game, the contract that paid $1 if the Yankees won the World Series was selling for 20 cents. It was known that the league that won the All-Star Game would win home-field advantage in the World Series. It is commonly believed that teams win more often than not when they have the homefield advantage, so the outcome of the All-Star Game was important to investor's beliefs about the odds of the World Series. The Yankees, seen as the most likely American League team to make it to the World Series, were seen as slightly more likely to win the World Series by investors after the All-Star Game. A contract that would pay $1 if the Yankees won the series was selling for 20 cents the day before the All-Star Game, but had climbed in price to 21 cents the day after. Investors took their new knowledge about homefield advantage in the World Series, and slightly upgraded the value of all the contingent contracts for American League teams and slightly downgraded the value of the National League teams.

Next we'll look at some more practical applications of how information influences price changes and how we can extract information from price changes on Page 4.

The Effect of Information on Market Prices

The effect of new information and changed beliefs are especially apparent in contingent contracts, but they also show up in the price of any asset. In quite a few articles, such as "Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut," I discuss the link between the differences in the interest rates in two countries and the exchange rate.

In short, the relationship between interest rates and currency exchange rates can be described as follows: if the interest rate in country A falls and the rate in country B stays the same, we'd expect to see A's currency become less valuable relative to B's, all else being equal.

 

Information Can Influence Price Before Events Happen

With that relationship in mind, take, for example, that we know that country A will be lowering its interest rate. With this information, we should expect that the A's currency will soon become less valuable than country B's. So we'd do well for ourselves if we sold A's currencies and bought B's on the open market. Of course, if everyone believes the interest rate drop is coming, everyone will pre-emptively sell currency A and buy currency B, until the price of currency A falls to the level it would be expected to be after the interest rate drop was officially announced.

Essentially, the price of the asset (country A's currency) would reflect the price the market believes it will be after the interest rate drop. The expected price drop will effectively precede the event that would actually cause the change. 

So if we all expect that the central bank of country A will drop rates by 25 points and they do, we should not expect to see any changes in the exchange rate at the time of the announcement as the price change would have already occurred.

However, if country A instead announces that they're not going to decrease the interest rate, we should see currency A rise back up to its former value, despite the fact that no tangible change in interest rate had actually occurred.

To the naive observer, it may even look like the drop in the exchange rate is causing the central bank of country A to lower its interest rate a few days later, an example of mistaken correlation versus causation that I look at in length in the article, "Do changes in stock prices cause recessions?"

 

Price Changes Ultimately Reflect Market Beliefs

By looking closely at these price changes, we can also learn a great deal about what the market expects. Suppose we know that the Federal Reserve Chairman is going to make an announcement next Tuesday. We can deduce investors' best predictions on the content of the announcement by watching exchange rates.

If the exchange rate drops or rises, we can deduce that investors believe that a change in the interest rate will be announced. If the exchange rate stays the same, however, the market is telling us that investors believe that no change will be made. Of course, this example is an oversimplification of the nature of the Federal Reserve's influence on the economy.

But even in this oversimplification, we can see that it is apparent that if we watch how market prices change, we can determine what the investment community feels will happen in the future.

 

The Principles of Supply and Demand

In a country with a free market economy, prices are not set by a central planning bureau but instead are set by supply and demand. Because the laws of supply and demand reflect the information and beliefs of investors in those markets, they contain the sum total of all the information and beliefs the investors have in a market. While we might not have the power to change people's actions or beliefs, the price mechanism gives us the power to observe and interpret those actions and beliefs, which means that prices are far more than just what you have to pay for something, they are also a source of great knowledge.

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Moffatt, Mike. "How Prices are Set in a Market Economy." ThoughtCo, May. 12, 2016, thoughtco.com/how-prices-are-set-in-a-market-economy-1146198. Moffatt, Mike. (2016, May 12). How Prices are Set in a Market Economy. Retrieved from https://www.thoughtco.com/how-prices-are-set-in-a-market-economy-1146198 Moffatt, Mike. "How Prices are Set in a Market Economy." ThoughtCo. https://www.thoughtco.com/how-prices-are-set-in-a-market-economy-1146198 (accessed December 11, 2017).