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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)

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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Bibliographic 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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Cited by:
  1. Amos Storkey, 2011. "Machine Learning Markets," Papers 1106.4509, arXiv.org.
  2. Stephanie Wang, 2012. "Speculative Overpricing in Asset Markets with Information Flows," Working Papers 489, University of Pittsburgh, Department of Economics, revised Jan 2012.

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