A strong internal control environment is one where pertinent information is identified, captured and communicated in a form and time frame that enables people to carry out their responsibilities.
Internet-based virtual stock markets (VSM) are an emerging approach that can improve the quality of information within an organization and can be used to predict future market developments and events of a business, political, or economic interest.
What is a VSM?
The basic idea of a VSM is to bring a group of participants together via the Internet and let them trade shares of virtual stocks. These stocks together represent a bet on the outcome of future market situations.
The theoretical background of VSMs is the so-called efficient market hypothesis, which states that a market is efficient if all available information is always fully reflected in the prices.
VSMs can be either open to the public or limited to say, a section within a company.
A company could have many VSMs running at any one time on a specific issue within the business or could have one big VSM covering all issues.
How does the information of market participants get reflected in the stock prices?
Suppose a VSM where participants can trade a type of stock that pays $1 for every 1,000 net adds a Sydney based telephony company expects in March 2006. The current price of this stock is $100, reflecting an expected net add of 100,000.
However, a participant at the VSM – lets call him Tom – thinks that 95,000 is a more realistic expectation because he has information about the imminent deal a potential customer has with a competitor headquarted in Melbourne.
Therefore he starts to sell shares at $100, which he thinks will only get a payoff of $95 each. Tom increases the supply of this stock, leading to a price below $100.
Tom’s new information is now reflected in the stock price.
The same logic applies if Tom thinks a stock is undervalued and buys. Thus, by trying to make a profit, it is Tom’s best strategy to make transactions according to his individual assessments of the future event’s outcome.
VSMs perform three tasks:
1. they provide incentives for truthful revelation
2. they provide incentives for research and information discovery
3. they provide an method for aggregating opinions
When Do VSMs Work?
VSMs can be applied to any quantifiable business forecasting problem where potential traders possess relevant knowledge.
There are three key elements of a successful VSM:
- The market situation or event must be quantifiable so that participants are able to assign a numeric value to their expectations. Possible prediction issues corresponding to specified events can be
1. the prediction of an absolute number (eg sales in a particular period)
2. the prediction of a relative number (eg market share in a particular period)
3. the occurrence or non-occurrence of a particular event (eg the completion of a development project at a particular point in time; litigation victory or successful product introduction) - Participants need to have some knowledge about the future market situation to be predicted. Thus, only a few experts among participants can be sufficient to achieve good predictions, but if no one has any information about the issue to be predicted, you might as well roll a dice.
- The incentive created by the payoff mechanism has to be sufficient for experts to invest their time and participate as well as reveal their true valuations.
Incentives for knowing information … tell me more
In order to create incentives for experts to participate and reveal their assessments of future market developments, a potential reward should be established according to the participant’s performance.
The first alternative is to require participants to invest their own money (say – putting a % of remuneration at risk) and to link their remuneration to their performance on the VSM. The idea is that investment of participants’ own money creates a strong incentive to perform well. However, some experts might not participate because they are unwilling to accept the risk of financial loss.
The second alternative is to waive a required investment and provide participants with an endowment of shares of virtual stocks and virtual money instead and to reward the best performing participants (based on the highest portfolio value).
Remember that a VSM can express information which otherwise might be buried in large documents or hierarchies and you need to create incentives to air such hidden piece of intelligence.
So who would participate in an internal VSM?
Anyone!
Related to forecasting, VSMs can be also applied to identify knowledgeable participants or experts within a company.
The basic idea of such an application is that a participant’s performance at a VSM can be used as an indicator of his or her knowledge and involvement in the issue to be predicted.
VSMs can be used as a tool to target knowledgeable employees or “trend scouts” which, for example, could be consulted for purposes of assessing the success of, say, a new product.
If participants are managers, the VSM can identify those with a good forecasting ability and market understanding, who could be promoted to positions that require this capability.Even further, this approach could be extended to the area of manager appraisal.
A company might link rewards to the forecast accuracy of their executives. Consequently, manager appraisal and remuneration could be based on a manager’s performance on a VSM for business forecasting problems.
All too theoretical – show me some real examples
On a company level, there are two examples that we came across:
- In a series of experiments, researchers at Hewlett-Packard enrolled some of their employees as prediction traders and found their forecasts of product sales systematically outperformed the official ones.
- A large German mobile phone operator used a VSM to forecast the usage of some of its different mobile phone services in a specific month. In this instance access was restricted to 20 selected employees in the marketing and planning departments of the company. The forecast accuracy of the VSM was better than all other methods of forecasting previously adopted.
Open to public “play money” VSMs include:
- The Global Risks Prediction Market (http://weforum.newsfutures.com/login/login.html ) - an initiative of this year’s World Economic Forum in Davos, Switzerland where it is used as a platform for aggregating information about global risks.
- The Hollywood Stock Exchange (http://www.hsx.com/) which focuses on box office returns and has correctly picked 35 of the last 40 major Oscar categories.
- NewsFutures’ World News Exchange (http://us.newsfutures.com/) whose sports and financial markets are operated jointly with USA Today.
- The Foresight Exchange (http://www.ideosphere.com/) which focuses on long-term scientific discoveries and some current events.
Open to public “real money” VSMs include:
- The Iowa Electronic Markets (www.biz.uiowa.edu/iem) which focuses on political election returns
- Tradesports (http://www.tradesports.com/) a betting exchange headquarted in Ireland.
This can’t work in every situation
You are right – and the Pentagon will be the first to tell you that.
In July 2003, the Pentagon abandoned plans for a futures market on terror where – according to the New York Times – “traders bullish on a biological attack on Israel, say, or bearish on the chances of a North Korean missile strike would have had the opportunity to bet on the likelihood of such events.”
This particular VSM created a political firestorm – with US Senators calling it “morally repugnant and grotesque”.
The Pentagon had failed to understand that the structure of their VSM – open to the public and liable to bias from ignorant or malicious sources – broke one of the commandments of a successful VSM – participants need to have some knowledge about the future market situation to be predicted and if the predicted events need to be confidential to limit the audience.
You have to choose your VSM carefully.
The devil is in the detail!
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