The Betfair Prof / Leighton Vaughan Williams / 27 April 2009 / Leave a comment

The Betfair Prof, Leighton Vaughan Williams, tells us how prediction markets might have made it even bigger!

It is for his idea that water is the essence of all matter that Thales of Miletus, the 6th century BC Greek philosopher, is best known. It is for his option trading, however, that he should be at least equally celebrated, as it is the first use of financial derivatives in recorded history.

Aristotle (in part XI of Book 1 of his 'Politics') relates the tale.

According to Aristotle's account, Thales put a deposit during the winter on all the olive-presses in Chios and Miletus, which would allow him exclusive use of the presses after the harvest. Because the harvest was in the future, and nobody could be sure whether the harvest would be plentiful or not, he was able to secure the contracts for a very low price. In fact, we are informed that there was not one bid against him. From the olive press owners' point of view, they were protecting themselves against a poor harvest by earning at least some money up front regardless of how things turned out.

Thales' bet came off, big time. The harvest was excellent and there was heavy demand for the presses. Thales held the monopoly and was able to rent them out at a huge profit. Either he was an expert forecaster or he had calculated that a bad harvest would not lose him much in terms of lost deposits, whereas the upside of a good harvest was enormous. "Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort", wrote Aristotle.

In effect, Thales had exercised the first known options contract, more than 2,500 years ago. Today we would term it as buying a 'call option', i.e. an option to buy something at some designated price at some future date for a fixed fee (or 'premium'). Put another way, it is an agreement that gives the purchaser the right (but not the obligation) to buy a commodity, stock, bond or other instrument at a specified price (the 'strike price') at the end of or within a specified time period. When the price exceeds the strike price, the option is said to be 'in the money'.

Properly used, options can be an excellent vehicle for managing risk. In this example from 6th century BC Greece, the owners of the olive presses were ensuring that they didn't lose their entire earnings in the event of a bad harvest. From Thales' point of view, he was confident in his forecast of the harvest, but was still taking some risk that he'd lose all the deposits he's paid. Today we'd say that he was risking not being able to exercise his call options.

I wonder how Thales and the olive-press owners might have used prediction markets if they'd been available 2,500 years ago. I guess the owners might 'sell' a market about the size of the harvest. In this way, they would earn a greater return the worse the harvest. And this is what risk management is all about. Thales, on the other hand, would presumably have used his supreme confidence in his forecasting powers to 'buy' the market as well as the options and make himself an even richer man than he became.

No need to worry. Thales' ambition, as Aristotle so aptly put it, was of another sort. Still, the money came in handy!

Professor Leighton Vaughan Williams is the Director of the Political Forecasting Unit and Betting Research Unit of Nottingham Business School, Nottingham Trent University