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Interpreting prediction market prices as probabilities

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Author Info
Justin Wolfers
Eric Zitzewitz

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Abstract

While most empirical analysis of prediction markets treats prices of binary options as predictions of the probability of future events, Manski (2004) has recently argued that there is little existing theory supporting this practice. We provide relevant analytic foundations, describing sufficient conditions under which prediction markets prices correspond with mean beliefs. Beyond these specific sufficient conditions, we show that for a broad class of models prediction market prices are usually close to the mean beliefs of traders. The key parameters driving trading behavior in prediction markets are the degree of risk aversion and the distribution on beliefs, and we provide some novel data on the distribution of beliefs in a couple of interesting contexts. We find that prediction markets prices typically provide useful (albeit sometimes biased) estimates of average beliefs about the probability an event occurs.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2006-11.

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Date of creation: 2006
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Handle: RePEc:fip:fedfwp:2006-11

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Keywords: Forecasting Financial markets Econometric models

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Charles F. Manski, 2004. "Interpreting the Predictions of Prediction Markets," NBER Working Papers 10359, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Andrew Leigh & Justin Wolfers & Eric Zitzewitz, 2003. "What Do Financial Markets Think of War in Iraq?," NBER Working Papers 9587, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Justin Wolfers & Eric Zitzewitz, 2004. "Prediction Markets," NBER Working Papers 10504, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Marco Ottaviani & Peter Norman Sørensen, 2007. "Aggregation of Information and Beliefs in Prediction Markets," FRU Working Papers 2007/01, University of Copenhagen. Department of Economics. Finance Research Unit. [Downloadable!]
  5. Steven Gjerstad, 2004. "Risk Aversion, Beliefs, and Prediction Market Equilibrium," Microeconomics 0411002, EconWPA. [Downloadable!]
  6. Jeff Dominitz & Charles F. Manski, 2004. "How Should We Measure Consumer Confidence?," Journal of Economic Perspectives, American Economic Association, vol. 18(2), pages 51-66, Spring. [Downloadable!] (restricted)
  7. Steven D. Levitt, 2004. "Why are gambling markets organised so differently from financial markets?," Economic Journal, Royal Economic Society, vol. 114(495), pages 223-246, 04. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Justin Wolfers & Eric Zitzewitz, 2006. "Five Open Questions About Prediction Markets," NBER Working Papers 12060, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Erik Snowberg & Justin Wolfers & Eric Zitzewitz, 2006. "Partisan Impacts on the Economy: Evidence from Prediction Markets and Close Elections," IZA Discussion Papers 1996, Institute for the Study of Labor (IZA). [Downloadable!]
    Other versions:
  3. Gürkaynak, Refet S. & Wolfers, Justin, 2006. "Macroeconomic Derivatives: An Initial Analysis of Market-Based Macro Forecasts, Uncertainty and Risk," CEPR Discussion Papers 5466, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  4. Wolfers, Justin & Zitzewitz, Eric, 2006. "Prediction Markets in Theory and Practice," CEPR Discussion Papers 5578, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  5. Erik Snowberg & Justin Wolfers & Eric Zitzewitz, 2006. "Party Influence in Congress and the Economy," NBER Working Papers 12751, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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