Here are my notes on the paper, Prediction Markets, by Justin Wolfers and Eric Zitzewitz
Wolfers and Zitzewitz recently published Interpreting Prediction Market Prices as Probabilities that claims that “prediction market prices are usually close to the mean beliefs of traders” and concludes…
Possibilities for Arbitrage
Gaming the Market
Small Probablility Events
Criteria for Success
For a prediction market to work well
1. Contracts must be clear, easily understood, and easily adjudicated.
2. A motivation to trade must exist. Perhaps simply through the thrill of pitting one’s judgment against others
3. There must be some disagreement about likely outcomes. “Disagreement is unlikely among fully rational traders with common priors. It is more likely to occur when traders are overconfident in the quality of their private information or in their ability to process public information or when they have priors that are sufficiently different to allow them to agree to disagree.”
4. There must be useful intelligence to aggregate. Public information cannot be selective, inaccurate, or misleading.
Types of contracts
All contracts assume risk neutrality – that risk doesn’t affect investors’ decisions becuase the amounts being wagered are small.
Winner-takes-all: contract pays off if and only if a specific event occurs. The price on a winner-take-all market represents the market’s expectation of the probability that an event will occur.
Index: contract pays off an amount that varies based on a numeric outcome, say, the percentage of the popular vote or the number of printers sold. The contract price represents the mean value that the market assigns to the outcome.
“Spread” betting: traders bid on the cutoff that determines whether an event occurs, like point-spread betting in football, where the bet is either that one team will win by at least a certain number of points, or will not. The price of the bet is fixed, but the size of the spread can adjust. When spread betting is combined with an even-money bet (that is, winners double their money while losers receive zero), the outcome can yield the market’s expectation of the median outcome because this is only a fair bet if a payoff is as likely to occur as not.
Families of winner-takes-all contracts can reveal the probability distribution of the market’s expectations.