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Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

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Author Info

  • Marco Ottaviani

    (Kellogg School of Management, Northwestern University)

  • Peter Norman Sørensen

    (Department of Economics, University of Copenhagen)

Abstract

In a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price is demonstrated to underreact to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first period price is followed by momentum.

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Bibliographic Info

Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 09-14.

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Length: 36 pages
Date of creation: Jul 2009
Date of revision:
Handle: RePEc:kud:kuiedp:0914

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Keywords: prediction markets; private information; heterogeneous prior beliefs; limited budget; underreaction;

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References

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Cited by:
  1. Cespa, Giovanni & Vives, Xavier, 2011. "Expectations, Liquidity, and Short-term Trading," CEPR Discussion Papers 8303, C.E.P.R. Discussion Papers.
  2. Cespa, Giovanni & Vives, Xavier, 2007. "Dynamic trading and asset prices: Keynes vs. Hayek," IESE Research Papers D/716, IESE Business School.
  3. Xavier Vives & Giovanni Cespa, 2011. "Higher Order Expectations, Illiquidity, and Short Term Trading," 2011 Meeting Papers 929, Society for Economic Dynamics.

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