A Comparison of Discounted Corporate Bonds and Pari-Mutuel Horse Betting; and A Normative Experiment On Convergence Through Internet Publication of Bond Market Odds.

By Paul Scheurer © 2000 OUTLINE

0. "You can never know the outcome, but you can know the odds." -- Sir Humphries Davy (1778-1829)

1. Significance of Odds vs. Probability %.

     (a) at racetrack, defines both "ex ante" probability and "ex post" payoff as 10-to-1 payoff means 1-out-of-10      probability.

     (b) all uncertainty or ambiguity is subsumed in odds, for all outcomes (win/lose) are perfectly foreseeable.

     (c) efficient under Samuelson's (1965) definition: "market quotation ... already contains ... all that can be known about      the future ...."

2. Bonds vs. Racetracks

     (a) both efficient markets of risk (Blum, et al, 1991; Ziemba and Hausch, 1987).

     (b) 90% of time, race won by one of top 3 horses by odds on tote board (Scott, 1981, Ziemba)

     (c) "the bond market is dominated by conservative investors who keep rather close tabs on a company's ability to repay      the principal." (Peter Lynch, 1994)

     (d) bond spreads (r-rf) widen well before an S&P/Moody's rating change (Weinstein, 1977)

     (e) racetrack passive strategy: bet on one of top 3 horses ranked by odds (Scott, 1981, Ian Fleming, 1956)

3. Normative Experiment

     (a) 1895 MN Legislation - state grain inspector and 1 cent/year for weekly postcard to farmers on prices in Minneapolis      and Duluth grain markets

     (b) choice of formulas (show)

     (c) even though CML with slope 1, still on contract curve of Edgeworth box

     (d) average YTM of top 3 bonds (lowest YTM) across bond rating and S.I.C. - so CML with slope 1(x) as proxy for bond      market odds.

     (e) Law of Gas Stations ("Law of One Price" in economics) is then applied to bond market