Iraq Wars and Financial Markets.pdf - Economica(2009 76...

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Using Markets to Inform Policy: The Case of the Iraq War By J USTIN W OLFERS n and E RIC Z ITZEWITZ w n Wharton, University of Pennsylvania CEPR, IZA and NBER w Dartmouth College Final version received 14 May 2008. 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. I NTRODUCTION When a government weighs a policy decision with important economic consequences, investors and other economic agents struggle to assess its likely effects. Normally, this struggle is conducted individually or in small groups and its outcome is not credibly observable to economists or policymakers. Experts can disseminate estimates of the likely effects of the policy, but their professed assessments suffer from a cheap talk problem and may be tainted by political expediency. Our analysis focuses instead on revealed choices in financial markets. Specifically, we exploit data from a prediction market (a small-scale market in securities whose payoffs are explicitly contingent on the policy being implemented) as an aid in extracting some of the rich information embedded in financial market prices about the likely implications of the policy. The prices of these prediction market securities provide an indication of the participants’ estimates of the probability of the contingency occurring. Examining the
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