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Rate cut the short priced favourite - Eureka Report article

August 29, 2008
Rate cut the short-priced favourite
By Scott Francis

PORTFOLIO POINT: Backing a 0.25% rate cut on Tuesday could make punters an instant, tax-free 12%.

They say there are two categories of economist: those who cannot forecast interest rates; and those who do not know that they cannot forecast interest rates.

In a curious twist of events, the online betting agency Centrebet has now introduced the chance for punters - and maybe economists - to have a bet based on interest rate outcomes.

So, if you see your local economist down at Centrebet putting $100 on the next interest rate movement, you'll know they fall into the second category.

Centrebet has entered the finance markets opening a "book" on an interest rate cut next Tuesday when the Reserve Bank meets to decide on rates policy.

So what are the odds? A 0.25% cut (the clear favourite) will return $1.12 for a $1 bet; rates staying on hold is paying $6 (an outside chance, but firming a little late on yesterday's reasonably strong business investment figure); a cut of more than 0.25% (an outside chance, hurt by the very strong business investment figure we've seen this week) is $6.50. The outsider - a rise of more than 0.25% - is paying $510.

So the "favourite" price of $1.12 means that a $100 bet will return you $112, or an instant, tax-free 12%.

Sounds good I suppose, but if rates don't move you lose all your money. That's where betting and investment go their separate ways.

There may be some useful practical application of the chance to bet on interest rates. For example, a retiree might be particularly concerned about a fall in interest rates of 0.5% or more, because of their reliance on high interest rates from their cash investments to fund the living costs. Putting a slice of their hard-earned on rates falling by 0.5% or more could be a useful hedge. If rates do fall, their win from Centrebet would compensate for lost interest-rate income.

If this seems far-fetched, remember that in reality this is what many businesses and speculators do ... not through Centrebet, rather through derivatives markets around the world.

There is a surprising amount of academic literature that looks at this topic. The area of most interest is that of "efficiency": how well do odds reflect the likely outcome?

Are there betting strategies that can earn an above average return? The general suggestion from the literature is that odds in sporting events are generally pretty efficient at predicting the likely outcome; it is difficult to have a profitable strategy through strategies such as always betting on the home/away team, or always betting on the favourite.

The sharemarket parallel is that the price of a share is like the odds on a sporting event. A good chance in a sporting contest has shorter odds, just as a high-quality company will have a higher share price compared to earnings.

Conversely, an outside chance at a sporting event has long odds and a poor quality (or out of favour) company a lower price compared to it earnings (think banks and their relatively low price/earnings multiples at the moment).

As news comes in (a race favourite has gone lame or a corporate takeover offer has emerged) the odds/share price changes to reflect that information.

And, to show that the Eureka Report is happy to deal with a broad range of matters financial, here is a little bit of advice on gambling. In 2005 Philip Gray, Stephen Gray and Timothy Roche wrote an article in the journal Accounting and Finance entitled A note on the efficiency in football betting markets: The economic significance of trading strategies. Their study looked at the ARL (Australian Rugby League) betting market, and found that betting on "home team underdogs" produced a median return of 21% over a season, a return that they described as "sufficient to generate profits that bettors would regard as economically significant".

To think that I had a solid investment portfolio, and now I find that it is underweight a home team underdog's sports betting strategy! Oh well, at least I don't spend my time betting on the favourites. I'd love to know what Reserve Bank governor Glenn Stevens thinks of it all.