Orange Juice and the Weather
The possibility that the predictive power of securities markets might provide information to businesses is in some sense nothing new. Commodity markets have long made it possible for small businesses to purchase commodities for delivery in the future and for speculators to trade these commodities in the hope of making a profit, thus providing market liquidity. The information that these markets provide can help businesses make sensible decisions. If it appears that one commodity seems likely to be expensive at some point in the future, for example, a business might invest in adjustments so that it can use another as a substitute. Indeed, businesses can do this even if they are not investing in the market themselves, because the price of futures contracts facilitates predictions. Businesses, for example, might find out well in advance that heating oil will be more expensive in the coming winter, either by directly consulting the futures markets or by reading or hearing about news reports that rely on them. This information could easily affect business decisions; for example, a business that is losing money might decide on the basis of this information to shut its doors, thus potentially saving it from larger losses. Studies suggest that commodity market prices do a remarkable job of incorporating information and making relevant predictions about the future. Richard Roll conducted a particularly interesting study, published in 1984, of the market for frozen concentrated orange juice.30 This commodity market will be familiar to many members of the movie-going public because it played a major role in the plot of the 1983 comedy Trading Places, starring Dan Aykroyd and Eddie Murphy. The premise of the film is that two wealthy commodity traders, placed by Don Ameche and Ralph Bellamy, decide to conduct a sociological experiment. They plot to destroy the career of a successful young trader, played by Aykroyd, and have him trade places with a street con artist played by Murphy. The film makes commodity trading appear easy, as Murphy’s character proves to be just as shrewd a trader as Aykroyd’s, parlaying simple insights about human behavior and tendencies into profits. In the end, the two exact revenge on Ameche’s and Bellamy’s, selling them a fake Agriculture Department report about farm conditions and leading them to make disastrous trades in the market for frozen concentrated orange juice. The market is thus portrayed as one in which individuals seek to cheat by obtaining insider information, but in which at the same time simple analysis can produce great profits. It is not surprising that Roll’s study shows that the market is somewhat more sophisticated than the movie might suggest. Roll chose orange juice as an object of study because an easily measurable variable, the weather, has significant effects on supply. Orange trees are particularly vulnerable to freezing temperatures, and so falling temperatures should decrease production and raise the price of orange juice futures. At the same time, Roll believed that there were relatively few other factors that would seem likely to produce significant demand and supply shocks. Roll’s research verified that weather predictions affected orange juice future prices. Astonishingly, however, Roll’s work demonstrated that the converse was also true: orange juice futures prices could help improve on weather forecasts by the National Weather Service. That is, Roll showed that these prices were statistically significant predictors of the service’s forecast error (the number of degrees by which the temperature would diverge from the service’s prediction). This suggests that some traders in the market might engage in relatively sophisticated analysis in order to predict price movements, considering not only publicly available data but also their own analyses. Alternatively, perhaps someone managed to transform many casual observations about the weather into a forecast that could improve on the National Weather Service’s. To be sure, the market might have been much less accurate if no National Weather Service forecasts existed, but the study suggests that commodity markets take into account both public and private information. The success of commodity markets at making predictions does not guarantee equal success for predictions generated by prediction markets. The market for frozen concentrated orange juice has substantial liquidity, and so a modestly subsidized prediction market might not perform nearly as well. An advantage of prediction markets, however, is that because they can be designed to predict virtually any variable, they can be customized to the particular needs of businesses. The orange juice market, by contrast, did not produce an explicit prediction of the weather, and it would not have been easy for a casual observer to look at the market price and decide to wear a warm coat. Moreover, a prediction market can provide much more directly targeted incentives to research weather than can an orange juice market, in which other factors may be involved as well. On the other hand, an advantage of the orange juice market is that it already has many investors. Prediction markets can be designed explicitly to forecast weather phenomena, and indeed there is at least one real-money prediction market devoted to weather, seeking to improve on official projections in tracking the path of hurricanes.31 Weather prediction markets also might produce up-to-the-second forecasts, showing clear probability distributions that could be useful to businesses that are sensitive to short-term weather fluctuations. That commodity market prices can be translated into predictions about the future is a happy artifact of an institution established for different purposes. Because prediction markets are designed specifically for the purpose of generating predictions, they can be more easily customized to make targeted and detailed predictions.
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