A Parimutuel Market Microstructure for Contingent Claims

Parimutuel principles are widely used as an alternative to fixed odds gambling in which a bookmaker acts as a dealer by quoting fixed rates of return on specified wagers. A parimutuel game is conducted as a call auction in which odds are allowed to fluctuate during the betting period until the betting period is closed or the auction ‘called’. The prices or odds of wagers are set based upon the relative amounts wagered on each risky outcome. In financial microstructure terms, trading under parimutuel principles is characterised by (1) call auction, non-continuous trading; (2) riskless funding of claim payouts using the amounts paid for all of the claims during the auction; (3) special equilibrium pricing conditions requiring the relative prices of contingent claims equal the relative aggregate amounts wagered on such claims; (4) endogenous determination of unique state prices; and (5) higher efficiency. Recently, a number of large investment banks have adopted a parimutuel mechanism for offering contingent claims on various economic indices, such as the US Nonfarm payroll report and Eurozone Harmonised inflation. Our paper shows how the market microstructure incorporating parimutuel principles for contingent claims which allows for notional transactions, limit orders, and bundling of claims across states is constructed. We prove the existence of a unique price equilibrium for such a market and suggest an algorithm for computing the equilibrium. We also suggest that for a broad class of contingent claims, that the parimutuel microstructure recently deployed offers many advantages over the dominant dealer and exchange continuous time mechanisms. 11 We would like to thank Ken Baron of Longitude, Darrell Duffie of Stanford University, and Michael Overton of the Courant Institute at NYU for providing critical insight and support. This article is based on Lange and Economides (2001). Proofs that are omitted in this published version can be found in Lange and Economides (2003) at http://www.stern.nyu.edu/networks/ Parimutuel.pdf European Financial Management, Vol. 11, No. 1, 2005, 25–49 # Blackwell Publishing Ltd. 2005, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. CSE: AR EUFM 002