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.
January 29th, 2007 10:52
I’m intrigued by your analysis, and inference that this borders on illegal gambling. In John Brunner’s ‘The Shockwave Rider’ he posited a future exchange market based on predicting future events. This market was called the ‘Delphi pool ‘ and everyone participated. Through aggregation and statistical analysis it was found that while no one ‘knew what was going on’, everyone as a weighted average could reasonably say what was going on.
Good write up.
January 31st, 2007 19:22
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February 1st, 2007 01:08
Greg, interesting analysis you have. If this is successfully implemented, does this mean the the merchants of the travel industry will become more price competitive than ever?
February 1st, 2007 11:30
Well that’s a very interesting question Gordon. A technically correct answer is beyond my expertise, though I’m sure there’s plenty of economic theory to support one or more well-reasoned answers.
With that caveat, 2 thoughts: 1 is that commodity travel sales (airlines, etc.) are inefficient markets by design - with the goal of maximizing profit for the sellers, even if some seats remain unsold, rather than creating a single, perfect price per seat such that supply exactly meets demand and all seats are sold. So, having derivatives out there is a way of monetizing that inefficiency that it seems to me only enables it to persist (and perhaps have higher Beta if we get to the point of exerciseable options that convey rights on inventory).
That said, the second thought is that a robust derivatives market would, on an aggregate basis, add to the corpus of data and lead to a better collective view of what efficient market prices would be (per the “Delphi pool” comment above and general ongoing thinking about information markets). For example, if an airline has 10 seats left priced at $1000, and they sell 1, they don’t necessarily know if dropping the price to $800 would lead to 2 additional sales or 7. Though they could probably predict it reasonably well from historical data, having live marketplaces placing value on call options at different prices for those specific seats would create more visibility and basis for determining “actual” value even while they maintain their price discipline.
February 2nd, 2007 17:39
What’s the Black-Scholes on a trip to Hawaii in February? Can I arbitrage that against a trip to Tahoe now that the snow’s all gone? Maybe pay for the difference with a trade on my futures contract on my utilities bill.
I knew I should have paid attention in Economics class!