The latest from the Fed’s prediction market…

Via Stan Jonas:

Stan Jonas in his own words:

What’s the BET post the March FOMC? The first rule of “betting” is that one must know what the current market odds are. As of today, there is no doubt as to what the “consensus” bet is. Popular press analogies to the Great Depression aside, there is really only one compound option that remains to be priced.1) When will the FED stop Easing? Currently close to 90% “probability” than one way or the other the FED will be done by June of 2008!!
2) Second: When will ‘everyone else’ believe that the FED will start tightening again. Currently 6 months post the conditioinal cessation by June. That is as the chart shows… high subjective probability that the market will be pricing a positive probability of tightenting at every FOMC meeting from 2009 on out.

The chart above… is not just a derived calibration… but to a large extent as in a perfect Heath Jarrow Morton world… each of the forward “probabilities” trades simultaneously.

Thus one can and does “trade” the probability that the FED will be tightning again in September of 2009… just as easily as one can trade the probability that it will be easing or tightening in April of 2008. These “tradeable” bets are then aggregated to derive the value of any fixed income instrument over the corresponding time period.

Being “right” as an investor is exactly what one would expect in a Keynesian/DeFinetti world. Being “right” means that your current subjective “bet” as to the probabilities turns out to be “correct”… not by say September 2009… which is a lifetime away… but by next week!

In fact, this prediction market has acheived the sure sign of maturity. Conditional bets dominate. What will happen if…..

For those with a technical bent and who are familiar with what has been going on in the global fixed income marketplace… the only interesting question should be: How does one derive “the probabilities”?

That’s essentially what the “marketmaker” or oddsmaker in this case gets paid for. Deriving the “hedge” that can capture the conditional probabilities that are being bet on.