Farecast’s Groundbreaking New Product

Farecast, the airfare pricing prediction service, just announced a new product called Fare Guard. The way it works is simple, but its implications are huge - nothing less than a consumer derivative market for one of our largest commodity products.

So let’s say you search for a trip between LAX and JFK, and Farecast predicts prices will stay about the same for the next 7 days. For $9.95, you can buy a guarantee that will refund you the difference if the price in fact rises contrary to their predictions (with proof of purchase - yes, you actually have to buy the ticket).

It makes mathematical sense on the face of it: if they’re wrong by an average margin of, say, $50 when they’re wrong, as long as they’re wrong less than 20% of the time, they come out ahead on this bet. Over time, they can adjust pricing, there’s some breakage (customers who never buy tickets, don’t bother to check, or fail to submit a claim), and presumably they could bias the system to model conservatively if they really wanted to, since the model doesn’t work in reverse. (It doesn’t protect you if Farecast predicted prices would go up, you buy a ticket, and in fact they go down.) Here’s a pretty interesting blog post detailing their predictive algorithms.

Why am I so excited about this? What this amounts to is in effect a 7-day call option on airfares. I’ve been privately predicting for some time that the travel industry would eventually turn out products like this, given how much consumer pain there is in airfare pricing uncertainty, but I’d always assumed an airline would pioneer it, finding a way to make the revenue earned from price protection (net of revenue lost from “exercies”) exceed the revenue earned from the yield management practices that lead to all that consumer pain.

Frankly, I think overall travel demand would go up under this model, because it could drive more favorable look-to-book ratios across the industry, and pull revenue from non-bookers (all those expired, out-of-the-money options are just free money). Over the long run, Farecast may either want to securitize their aggregate one-way bet anyway, tie it to actual inventory lock-in, or launch a product that lets them take bets the other way - and airlines would make natural partners in these efforts.

But what really excites me about this is the fact that this secondary market is extractedby 3rd parties from published data and can be augmented by social data. Frankly, I’m surprised it’s not illegal (since it effectively is similar to gambling or an unregulated derivative security). It’s not even technically a derivative, since it can’t truly trade independently (e.g., you can’t sell it) and it doesn’t convey control of an underlying asset.

But If Farecast can do this, couldn’t they offer a whole spread of similar products (put options, collars, etc.)? What if Zillow, for $1,000 a month, offered you downside protection on the value of your local housing index falling? What if you could convert any car you owned outright into a lease-like structure, by locking in a residual price option (with adjustments for condition and mileage) with Kelly Blue Book, 2 years before you’re ready to sell it to Carmax?

Car leasing, ARM’s, and cell phone plans prove that consumers can handle complicated pricing & financing models. I’m very excited by the promise of the Web2.0-enabled next generation of that.