Parimutuel Applications in Finance: New Markets for New by Ken Baron

By Ken Baron

Monetary intermediaries as a rule supply derivatives to their shoppers in basic terms once they can hedge the exposures from those transactions. Baron and Lange express that parimutuel auctions can be utilized by means of monetary intermediaries to supply derivatives with no exposing themselves to chance.

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The inthe-money payout for the buyer of the first state claim is based on the total premium in the auction, which is his/her premium invested plus the premium of the other buyers of state claims in the auction. In parimutuel matching, all trades in an auction are executed at the same instant in 20 PARIMUTUEL APPLICATIONS IN FINANCE time (when the auction is called), and this allows orders to be filled across multiple parties and multiple derivatives. Thus, with parimutuel matching, there does not necessarily exist a party with the exact opposite risk to each buyer.

The most widely known such system is the “Dr. Z System,” named after William Ziemba. As described by Hausch, Ziemba, and Rubinstein (1981), Hausch and Ziemba (1985), and Ziemba and Hausch (1987), this strategy capitalizes on the empirical finding that horses likely to win a race are often underbet in the place and show pools. Ziemba and Hausch (1987) confirm with historical data and with several trips to the racetrack that selectively wagering on the favorite or the near favorite to place or show can yield profitable results.

Each state corresponds to a single value or multiple values of U. With multiple values in certain states, we can partition the sample space so that the total number of states is finite, making the mathematics tractable. Let S denote the number of those states, and let s and s˜ denote state index numbers. If s < s˜ , we require that all values of U in state s are less than all values of U in state s˜ . Thus, a higher state number implies a higher value of the underlying U. The CPI example: Assume that the underlying U is the monthly change in US CPI measured in percentage terms over a specified month.

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