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Interpreting prediction market prices as probabilities

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  • Justin Wolfers
  • Eric Zitzewitz

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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Bibliographic Info

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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  1. 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.
  2. Wolfers, Justin & Zitzewitz, Eric, 2004. "Prediction Markets," Working paper 259, Regulation2point0.
  3. Charles F. Manski, 2004. "Interpreting the Predictions of Prediction Markets," NBER Working Papers 10359, National Bureau of Economic Research, Inc.
  4. 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.
  5. Steven Gjerstad, 2004. "Risk Aversion, Beliefs, and Prediction Market Equilibrium," Microeconomics 0411002, EconWPA.
  6. Ali, Mukhtar M, 1977. "Probability and Utility Estimates for Racetrack Bettors," Journal of Political Economy, University of Chicago Press, vol. 85(4), pages 803-15, August.
  7. repec:reg:rpubli:259 is not listed on IDEAS
  8. 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.
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