# Election Predictions as Martingales: An Arbitrage Approach

July, 2019

Abstract

A standard result in quantitative finance is that when the volatility of the underlying security increases, arbitrage pressures push the corresponding binary option to trade closer to 50%, and become less variable over the remaining time to expiration. Counterintuitively, the higher the uncertainty of the underlying security, the lower the volatility of the binary option. This effect should hold in all domains where a binary price is produced – yet we observe severe violations of these principles in many areas where binary forecasts are made, in particular those concerning the U.S. presidential election of 2016. We observe stark errors among political scientists and forecasters, for instance with 1) assessors giving the candidate D. Trump between 0.1% and 3% chances of success , 2) jumps in the revisions of forecasts from 48% to 15%, both made while invoking uncertainty. Conventionally, the quality of election forecasting has been assessed statically by De Finetti’s method, which consists in minimizing the Brier score, a metric of divergence from the final outcome (the standard for tracking the accuracy of probability assessors across domains, from elections to weather). No intertemporal evaluations of changes in estimates appear to have been imposed outside the quantitative finance practice and literature. Yet De Finetti’s own principle is that a probability should be treated like a two-way "choice" price, which is thus violated by conventional practice.

In this paper we take a dynamic, continuous-time approach based on the principles of quantitative finance and argue that a probabilistic estimate of an election outcome by a given "assessor" needs be treated like a tradable price, that is, as a binary option value subjected to arbitrage boundaries (particularly since binary options are actually used in betting markets). Future revised estimates need to be compatible with martingale pricing, otherwise intertemporal arbitrage is created, by "buying" and "selling" from the assessor.