PAM- Contracts Example

To illustrate the sort of contracts tradable on PAM, consider two issues tied to the now-historic case of pending hostilities between the United States and Iraq: (a) whether or not the Jordanian monarchy would be overthrown during hostilities between the United States and Iraq and (b) the ability of the Iraqi regime to persist for more than one month of hostilities. Each of these issues has two states; they occur or do not occur. A pair of futures contracts can therefore be defined for each issue and only one of each pair can end up as true:

To illustrate why such futures contracts would be traded, consider two PAM traders: a specialist in Jordanian domestic affairs and a specialist in U.S. military planning and operational capabilities – the first would feel comfortable trading in A and ~A while the second would feel comfortable trading in B and ~B. But what about the potential for interaction between these issues and how can these two specialists comfortably express their views on interactions that only partially involve their expert knowledge? This is a job for PAM derivatives.

The cells that form the outside of the table below illustrate the four futures contracts that span the two issues. The PAM trading system makes sure that the prices for the futures contracts that span an issue add up to $1.00; thus, a price is also a prediction; e.g., $0.35 = 35% prediction of A. The inner four cells of the table represent the joint outcomes for these two issues – the PAM trading system prices these so that they are equivalent to predictions as well.

A PAM trader who feels comfortable with both issues may choose to trade a contract in a joint outcome, a type of derivative. However, neither of the two PAM traders described above would be comfortable trading a joint derivative contract, which does not mean that such a trader has no information about joint outcomes.

The specialist in Jordanian domestic affairs may have a strong opinion that should the Iraqi regime persist beyond one month, the Jordanian monarchy will most likely fall. However, this PAM trader has no special knowledge of how U.S. military capabilities compare to Iraqi capabilities or of how the U.S. military intends to utilize its capabilities. For this trader, the conditional derivative, or hedge, is quite powerful. The conditional derivative allows the Jordanian domestic affairs specialist to leverage her knowledge of an effect (A) by hedging against her relative ignorance of a cause (B) – if the cause does not occur, then she does not lose any money, but if the cause does occur and the effect as well, then she can make a handsome profit.