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Aggregation of Information and Beliefs in Prediction Markets

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Author Info
Marco Ottaviani (London Business School)
Peter Norman Sørensen (Department of Economics, University of Copenhagen)

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Abstract

We analyze a binary prediction market in which traders have heterogeneous prior beliefs and private information. Realistically, we assume that traders are allowed to invest a limited amount of money (or have decreasing absolute risk aversion). We show that the rational expectations equilibrium price underreacts to information. When favorable information to an event is available and is revealed by the market, the price increases and this forces optimists to reduce the number of assets they can (or want to) buy. For the market to equilibrate, the price must increase less than a posterior belief of an outside observer.

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File URL: http://www.econ.ku.dk/Fru/WorkingPapers/PDF/2007/AIBIPM2.pdf
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Publisher Info
Paper provided by University of Copenhagen. Department of Economics. Finance Research Unit in its series FRU Working Papers with number 2007/01.

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Length: 26 pages
Date of creation: May 2007
Date of revision:
Handle: RePEc:kud:kuiefr:200701

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

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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  1. Justin Wolfers & Eric Zitzewitz, 2006. "Interpreting Prediction Market Prices as Probabilities," NBER Working Papers 12200, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. Marco Ottaviani & Peter Norman Sørensen, 2006. "Noise, Information, and the Favorite-Longshot Bias," FRU Working Papers 2006/04, University of Copenhagen. Department of Economics. Finance Research Unit. [Downloadable!]
    Other versions:
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