Have an open market in futures contracts on sporting events. For example, you may buy a contract from me in which I promise, on November 1, to pay you $1 if the New York Yankees have won the 2000 World Series, and which otherwise is worthless.
How much would you pay for such a contract? Ten
cents? Five? If I think the contract is worth five cents and you think it is worth seven, then you can buy a thousand such contracts from me for sixty dollars, and we have a bet. If the Yankees win, I owe you a thousand dollars, and if they lose, I keep your money.
What makes this more interesting than regular betting is that contracts are exchangeable.
We can have a market. People with better information about the Yankees' true chances to win will be able to exploit that knowledge, and the price of contracts will converge on the true value.
To see why this is, let's take a simple example:
Suppose that I could buy a
`heads' contract that would pay me $1.00 if the Super Bowl coin flip
next January came up heads, and let's imagine similar `tails'
contracts. In a free market, the two prices you must pay for these
two contracts will always sum to $1.00. Why? If the two prices are
each less than $.50, then it's easy to see how to make money: Buy one
of each contract, wait until January, collect your inevitable dollar, and pocket the difference. In a
well-run market, lots of people will do this immediately, and the
prices for both contracts will rise, because many people are trying to
buy contracts. If the two prices are both greater than $.50 each,
it's also easy to to make a profit: Sell a lot of contracts, in pairs.
Each pair sells for more than $1.00 total, so after you pay
off the lucky winners in January, you have some money left over.
Many people trying to sell contracts will force down the prices. If
one contract sells for more that $0.50 and one for less, you can still
make money with a slightly riskier strategy: Buy the cheap contract
and sell the expensive one. You might lose this year, but your
expected earnings are positive, so over the long run, you'll win.
Lots of people buying the cheap contract and selling the expensive one
will force the prices closer toegther, since demand for the expensive
contract will drop and demand for the cheap contract will rise. The
equilibrium point in the coin flip market is when the price for each
contract is exactly $0.50, and prices will tend to converge to this
point and stay there. Taking advantage of price inconsistencies in
financial markets in this way is called `arbitrage,' and people make
lots of money doing it on the stock market.
The Las Vegas odds for sports events are always some round number like 100-1 or 50-1, never anything weird like 73.6-1. But of course there's no reason why the real odds should be round numbers. A sports even futures market would gather as much information as possible to arrive at a truer estimate of the real odds.
Arbitrage becomes possible: If you've sold a thousand Yankees contracts at seven cents each, and then the Yankee's star pitcher breaks his arm and contract prices go down to six cents, you can get rid of your risky contracts, which might cost you a thousand dollars in November, in an easy way: Buy a thousand six-cent contracts. You're left with an immediate profit of $10. If the Yankees lose, all the contracts are void; if the Yankees win, you get $1000 that you can use to pay off the contracts that you sold.
FInally, you can use sports event futures the way manufacturers do: As a hedge fund. Suppose you're a Yankees fan and the Yankees are facing the Philadelphia Phillies in the World Series this year. Buy a few contracts on the Phillies. Then if the Yankees do lose, at least you have valuable Phillies contracts as consolation.