Hurricane Futures Market David Letson, David Nolan

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Hurricane Futures MarketDavid Letson, David
Nolan David KellyUniversity of MiamiForrest
NelsonUniversity of Iowa
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Heres Where I Work
Q Does Economics Really Belong Here?
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Is HFM Wagering? You Betcha.
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Is HFM Gallows Humor? No Way.
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Hurricanes Economics
Q Is hurricane forecasting an economic
problem? If goal is to save lives, reduce
injuries or minimize economic impacts of
hurricanes then YES hurricane forecasting is (by
definition) an economic problem. Q Is economic
research essential to solving problem? YES!
Regardless of hurricane forecasts skill, economic
research improves how people communicate,
perceive, understand, respond to value
forecasts. Message Economic research creates
enormous value.
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Ten Most Costly Hurricanes in US History,
(Insured Losses, 2005)
Seven of the 10 most expensive hurricanes in US
history occurred in the 14 months from Aug. 2004
Oct. 2005 Katrina, Rita, Wilma, Charley, Ivan,
Frances Jeanne
Sources ISO/PCS Insurance Information
Institute.
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Government Aid After Major Disasters (Billions)
Hurricane Katrina aid will dwarf aid following
all other disasters. Congress may authorize
150-200 billion ultimately (about 400,000 for
each of the 500,000 displaced families). Is the
incentive to buy insurance and insure to value
diminished?
Within 3 weeks of Katrinas LA landfall, the
federal government had authorized 75B in
aidmore than all the federal aid for the 9/11
terrorist attacks, 2004s 4 hurricanes and
Hurricane Andrew combined! 29B more was
authorized in Dec. 2005. At least 80B more is
sought.
In 2005 dollars. Source United States Senate
Budget Committee, Insurance Information Institute
as of 12/31/05.
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Hurricane Damage from Top 10 Hurricanes Since
1900 Adjusted for Inflation, Growth in Coastal
Properties, Real Growth in Property Values
(Billions of 2004 Dollars)
Great Miami Hurricane
Hurricanes causing 50B in economic losses will
become more frequently
Includes damage form wind and storm surge but
generally excludes inland flooding. Source Roger
Pielke and Christopher Landsea, December 2005
Insurance Info. Institute.
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How Do We Solve This Economic Problem?

• Should we find an expert? Form a committee?
• Winston Churchill opted for committees when he
  endorsed democracy as the least-bad form of
  government.
• Much is at stake. Not just hurricane hunting, but
  also how we should run businesses and
  governments.

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Experts May Be Hard to Find
No one in this world, so far as I know, has
ever lost money by under-estimating the
intelligence of the great masses of the plain
people. H.L. Menken
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Committees Dont Always Work
Men think in herds. They recover only their
senses slowly, and one by one. Charles Mackay
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Car Talk

• Hypothesis Do two people who don't know what
  they are talking about know less than one person
  who doesn't know what he's talking about?
• One person will only go so far out on a limb in
  his construction of deeply hypothetical
  structures, and will often end with a shrug or a
  raising of hands to indicate the dismissability
  of his particular take on a subject.
• With two people, the intricacies, the gives and
  takes, the wherefores and why-nots, can become a
  veritable pas-de-deux of breathtaking
  speculation, inter-woven in such a way that
  apologies or gestures of doubt are rendered
  unnecessary.

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Stupidity in Numbers?

• Anyone taken as an individual is tolerably
  sensible and reasonable, as a member of a crowd
  he becomes a blockhead. Bernard Baruch
• The Mass never comes up to the standard of its
  best member, but on the contrary degrades itself
  to a level with the lowest. Henry David Thoreau
• Madness is the exception in individuals, but the
  rule in groups. Nietzsche
• I do not believe in the collective wisdom of
  individual ignorance. Thomas Carlyle
• Crowds cannot accomplish acts demanding a high
  degree of intelligence. They are always
  intellectually inferior to the isolated
  individual. Gustave Le Bon

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Sometimes Groups Are Smart

• Francis Galtons ox
• 1906 West of England Fat Stock and Poultry
  Exhibition.
• Contest to guess dressed weight.
• 787 guess. Non-experts.
• Ho Only a very few people have the
  characteristics necessary to keep societies
  healthy. Breeding matters.
• Average of all guesses 1187 lbs. Correct answer
  1198 lbs.
• The average competitor was probably as well
  fitted for making a just estimate of the dressed
  weight of the ox, as an average voter is of
  judging the merits of most political issues.

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Finding a Lost Submarine

• In May 1968 the U.S. submarine Scorpion
  disappeared on its way back to Newport News after
  its North Atlantic tour.
• Search area was a circle 20 miles wide, under
  thousands of feet of water.
• Navy assemble an expert team. Mathematicians,
  submarine experts, salvagers. Each member was
  asked to guess, with Chivas Regal as the prize.
• Five months later, the Scorpion was found 220
  yards from average guess of panel.

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Wisdom as an Emergent Pattern

• An emergent behavior or emergent property can
  appear when a number of simple entities (agents)
  operate in an environment, forming more complex
  behaviors as a collective.
• The complex behavior or properties are not a
  property of any single such entity, nor can they
  easily be predicted or deduced from behavior in
  the lower-level entities they are irreducible.
  No physical property of an individual molecule of
  air would lead one to think that a large
  collection of them will transmit sound. The shape
  and behavior of a flock of birds or shoal of fish
  are also good examples.
• The stock market is an example of emergence on a
  grand scale. As a whole it precisely regulates
  the relative prices of companies across the
  world, yet it has no leader there is no one
  entity which controls the workings of the entire
  market. Agents, or investors, have knowledge of
  only a limited number of companies within their
  portfolio, and must follow the regulatory rules
  of the market and analyze the transactions
  individually or in large groupings. Trends and
  patterns emerge which are studied intensively by
  technical analysts.

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Efficient Market Hypothesis

• Two economists are walking down the street. One
  sees a dollar lying on the sidewalk, and says so.
  "Obviously not," says the other. "If there were,
  someone would have picked it up!"

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Smart Ants?

• The queen does not give direct orders and does
  not tell the ants what to do. Instead, each ant
  reacts to stimuli in the form of chemical scent
  from larvae, other ants, intruders, food and
  build up of waste, and leaves behind a chemical
  trail, which, in turn, provides a stimulus to
  other ants.
• Each ant is an autonomous unit that reacts
  depending only on its local environment and the
  genetically encoded rules for its variety of ant.
  
• Despite the lack of centralized decision making,
  ant colonies exhibit complex behavior and have
  even been able to demonstrate the ability to
  solve geometric problems. For example, colonies
  routinely find the maximum distance from all
  colony entrances to dispose of dead bodies.

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When Are Crowds Smart?

• Necessary conditions
• Cognitive Diversity lots of ideas, dissent
• Independence no imitation or groupthink
• Efficient aggregation.
• Examples
• Stock market reaction to Morton Thiokol,
  immediately following the 1986 Challenger
  disaster.
• Horse racing and other sports gambling
• Googles PageRank algorithm
• Iowa Electronic Markets prediction markets for
  elections

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2004 The Year That Was

• 15 trop storms hurricanes
• Charley, Frances, Ivan and Jeanne came too close.
• Presidential Election
• Toggling between NHC and IEM websites
• An idea was born Hurricane Futures Market

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The Hurricane Futures Market is a collaborative
research project between the University of Iowa
Tippie College of Business, the University of
Miami School of Business and the UM Rosenstiel
School of Marine and Atmospheric Science. The
Hurricane Futures Market is an experimental
research tool and is not a hurricane track
forecast. http//hurricanefutures.miami.edu/ind
ex.shtml
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How Does It Work?

• H0 Can a hurricane event market efficiently
  aggregate a larger body of expert opinion on
  hurricane track forecasts?
• Each time a new hurricane or tropical storm is
  named, we create a set of securities each with a
  specific longitude and latitude.
• One dollar is paid to the owner of a security
  with the geographic coordinates matching where
  the storm makes its first U.S. landfall.
• HFM does not earn or lose money but serves as a
  research and educational tool.

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Atlantic Storm Zones

• ID Coordinates Nautical Miles Near
• A1 80.3oW, 26.5oN 76.0 Boynton Beach, FL
• A2 26.5oN, 28.9oN 151.8 Oak Hill, FL
• A3 28.9oN, 31.8oN 174.2 Middle Place, GA
• A4 31.8oN, 33.0oN 119.0 McClellanville, SC
• A5 33.0oN, 76.8oW 191.4 Emerald Isle, NC
• A6 76.8oW, 36.1oN 99.9 Kitty Hawk Beach, NC
• A7 36.1oN, 72.2oW 330.1 East Hampton, NY
• A8 72.2oW, 66.95oW 390 Eastport, ME
• AX   Expires w/out US Landfall
• AW West of 80.3oW Enters Gulf Basin

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Hurricane Ophelia (Sept 7-19)

• 27 traders participated. The level of activity
  varied greatly by trader, with a few buying as
  few as 3 or 4 shares, and one glutton buying over
  2600.Five traders made 40 or more, while five
  lost 50 or more. The max win was 58, while the
  max loss was 80. Looks like some folks were
  confident about a Carolina landfall that never
  quite happened.More active traders tended to
  make more money. The simple correlation between
  shares bought and profits is 0.3.
• A third of all trades occurred on the first day
  we opened the market (Sept 7). Sept 9 was also an
  active day (19 of all trades).The asset
  trading hands most frequently was the (correct)
  expires security.Asset 5, corresponding to the
  Carolinas, also saw much activity, while the W
  security (enters the Gulf basin) saw little
  trading. The market took quite a while to
  converge, reflecting the disagreement of the
  forecast models. On Sept 13, the closing price
  for asset 5 was 85 cents. The price for the
  expires security did not exceed 50 cents until
  Sept 14.

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What Can the Prices Tell Us?

• Prices as Probabilities of Hurricane Risk.
• Two basic questions
• (1) What do hurricane strike probabilities mean?
  
• (2) How should we assign quantitative values to
  actual hurricane events?
• Hurricanes are not the repeatable trials required
  by frequentists.
• A Bayesian approach would conceive of an ensemble
  of possible hurricane events.

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Bayesian Framework

• Use hurricane track forecast, x, to update
  probability distribution for landfall location,
  s, according to Bayes rule

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Are Traders Bayesian?

• We need to know more about how good forecasts
  tend to be, i.e., p(xs).
• Given a landfall at s, what is the probability
  that the forecast would be correct, i.e., xs?
• Knowing p(xs) would allow us to test whether
  prices evolve according to Bayes Rule.
• If experts somehow get it wrong, what should we
  expect from lay users?

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Track Errors
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Future Directions

• Are traders rational Bayesians?
• Do traders understand probablistic forecasts?
• Which forecasts do traders trust and use?
• What about markets for seasonal forecasts?

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• HFM uses cutting-edge science to benefit risk
  awareness and profitability within the energy,
  (re)insurance and claims management industries.
• A series of further innovative business-relevant
  developments are planned for the near future.
• HFM is keen to seek partnerships with companies
  interested in applying and developing the
  business potential of its innovative products.

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Source NOAA Press Release, 30 Nov 2006
http//www.noaanews.noaa.gov/stories2006/s2748.ht
m
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HedgeStreet.com

• A rival, but without scholarly ambitions.
• Two classes of so-called binary contracts,
  whose values are based on insurance-claims
  estimates provided by Insurance Services Office
  (ISO)
• insurance-claim estimates for the entire Atlantic
  hurricane season contract values with damages
  above 100 million, above 1 billion, 10 billion
  and 25 billion.
• preliminary damage assessments caused by an
  individual hurricane or tropical storm