Here are my notes on the paper, Prediction Markets, by Justin
Wolfers and Eric Zitzewitz
Accuracy
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…
with
some guidance for practitioners. In most cases we find that prediction
market prices aggregate beliefs very well. Thus, if traders are
typically well-informed, prediction market prices will aggregate
information into useful forecasts. The efficacy of these forecasts may
however be undermined somewhat for prices close to $0 or $1, when the
distribution of beliefs is either especially disperse, or when trading
volumes are somehow constrained, or motivated by an unusual degree of
risk-acceptance.
Limitations
Thin Markets
…the HP (forecasting printer sales) and Siemens (predicting delivery
of sofware on schedule) experiences suggested that motivating employees
to trade was a major challenge. In each case, the firms ran real money
exchanges, with only a relatively small trading population (20-60
people), and subsidized participation in the market, by either endowing
traders with a portfolio or matching initial deposits. The predictive
performance of even these very thin markets was quite striking.
Possibilities for Arbitrage
Prediction markets appear to present few opportunities for arbitrage.
Gaming the Market
In most cases, the time series of prices in these markets does not
appear to follow a predictable path and simple betting strategies based
on past prices appear to yield no profit opportunities.
Small Probablility Events
People tend to overvalue small probabilities and undervalue near
certainties (The “volatility smile” in options refers to a related
pattern in financial markets.) It is likely that prediction markets
will also perform poorly at predicting small probability events.
Another behavioral bias reflects the tendency of market participants to
trade according to their desires, rather than their objective
probability assessments. …as long as marginal trades are
motivated by profits rather than partisanship, prices will reflect the
assessments of (unbiased) profit motive.
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.
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