In this episode the team investigates the death of a man (Danny) at a horce racing track. Danny had been able to pick the winning horse in the last 30 races he had bet on. Had there not been any foul play involved, this would be extremely unlikely (there are typically 10 horses in each race). Danny had been using a system of betting that his girlfriend (who had a Masters degree in Mathematics from Stanford) had developed to pick out the second most likely horse to win a race. She developed this system in order to take advantage of the higher expectation of betting on the second best horse arising from parimutual betting. When Danny noticed that it was the second best horse that had been winning consistantly, he suspected that the races were being fixed, and took advantage of it.

Parimutual betting is performed at horse tracks all over the globe. Rather than a professional gambler determining the proper odds for a race (based on knowledge of the horses and experience), this system allows bettors to determine the odds by themselves. We'll give a simple example of a payout system where only bets for the winning horse pay off money. Suppose that the track is running a 5 horse race, and say that bets are placed as follows.

Horse 1 $4000 | Horse 2 $1000 | Horse 3 $9000 | Horse 4 $2000 | Horse 5 $14000 |

The total amount bet is $30,000. First the house takes its cut (to be concrete we'll assume this is 15%, leaving $27,000). Then anyone who bet $1 on horse 3 will get $27000/9000 = $3. We can see that Parimutual betting guarantees the house a profit, since it always pays out exactly what it took in minus the cut (of course, we're assuming the cut covers the cost of operation and no laws interfere). Now, why is it that Danny and his girlfriend were concerned with finding a way to pick the second most likely to win? Since the odds are set by the bettors they may not actually reflect the true odds of a horse winning a race. Most bettors will concentrate on the best horse and place there bets there, often forgetting about the second best. Suppose that this had happened in our race, and that the actual odds for each horse to win had been

Horse 1 13% | Horse 2 4% | Horse 3 35% | Horse 4 8% | Horse 5 40% |

Then our expectation of a $1 bet on Horse 5 is 27000/14000*.4 - 1*.6= $.171 and the expected value of a bet on Horse 3 is $27000/9000*.35-.65*1 = $.4, which is far greater than that of Horse 5. (See here or here for a reminder of what an expected value is.) Now, when the track owners were fixing the races, they would pick the second best horse to be the winner because it would cause less suspiscion than making a worse horse win.

The parimutuel system was invented by Parisian perfume maker Joseph Oller in 1865 when asked by a
bookmaker friend to devise a fair system for bettors which guarantees a fixed profit for the bookmaker.

Outcome 1 Outcome 2 |
Bookmaker 1 1.30 3.56 |
Bookmaker 2 1.5 2.61 |

For each bookmaker, the sums of the inverse of all outcomes will always be greater than one. This is the bookmakers

Now if we place a $1000 bet on Outcome 1 with Bookmarker 2 and a bet of $1000*1.5/3.56=$421.35 on Outcome 2 with Bookmaker 1, we will have taken up an arbitrage strategy. Let's make sure. If Outcome 1 happens we win $1000*1.5 from Bookmaker 2, if Outcome 2 happens we win $$421.35*3.56=$1500. Since we invested $1421.35 we are guaranteed a profit of $88.65 either way.

Every wonder why the price of a stock on the NYSE and its corresponding futures contrace on the Chicago Mercantile Exchange are the same? The answer is arbitrage. If there were ever a difference in the price of some particular stock, one could buy that stock in the cheaper marker and sell it at the same time in the more expensive market. Many investment companies have complicated computer programs that track opportunities for arbitrage (many are more complicated than this simple example) and try to take advantage of them as quickly as possible. For more info on arbitrage see here.