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Risk Aversion, Beliefs, and Prediction Market Equilibrium

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  • Steven Gjerstad

    (University of Arizona)

Abstract

Manski [2004] analyzes the relationship between the distribution of traders’ beliefs and the equilibrium price in a prediction market with risk neutral traders. He finds that there can be a substantial difference between the mean belief that an event will occur, and the price of an asset that pays one dollar if the event occurs and otherwise pays nothing. This result is puzzling, since these markets frequently produce excellent predictions. This paper resolves the apparent puzzle by demonstrating that both risk aversion and the distribution of traders’ beliefs significantly affect the equilibrium price. For coeffcients of relative risk aversion near those estimated in empirical studies and for plausible belief distributions, the equilibrium price is very near the traders’ mean belief.

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File URL: http://128.118.178.162/eps/mic/papers/0411/0411002.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Microeconomics with number 0411002.

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Length: 17 pages
Date of creation: 04 Nov 2004
Date of revision:
Handle: RePEc:wpa:wuwpmi:0411002

Note: Type of Document - pdf; pages: 17
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Web page: http://128.118.178.162

Related research

Keywords: Asset pricing; beliefs; competitive equilibrium; prediction markets; risk aversion;

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References

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  1. Thaler, Richard H & Ziemba, William T, 1988. "Parimutuel Betting Markets: Racetracks and Lotteries," Journal of Economic Perspectives, American Economic Association, vol. 2(2), pages 161-74, Spring.
  2. Charles F. Manski, 2004. "Interpreting the Predictions of Prediction Markets," NBER Working Papers 10359, National Bureau of Economic Research, Inc.
  3. Charles R. Plott & Jorgen Wit & Winston C. Yang, 2003. "Parimutuel betting markets as information aggregation devices: experimental results," Economic Theory, Springer, vol. 22(2), pages 311-351, 09.
  4. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
  5. Forsythe, Robert & Forrest Nelson & George R. Neumann & Jack Wright, 1992. "Anatomy of an Experimental Political Stock Market," American Economic Review, American Economic Association, vol. 82(5), pages 1142-61, December.
  6. Yaw Nyarko & Andrew Schotter, 2002. "An Experimental Study of Belief Learning Using Elicited Beliefs," Econometrica, Econometric Society, vol. 70(3), pages 971-1005, May.
  7. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
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Cited by:
  1. Erik Snowberg & Justin Wolfers & Eric Zitzewitz, 2012. "Prediction Markets for Economic Forecasting," CAMA Working Papers 2012-33, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  2. He, Xue-Zhong & Treich, Nicolas, 2013. "Heterogeneous Beliefs and Prediction Market Accuracy," LERNA Working Papers 13.05.392, LERNA, University of Toulouse.
  3. Paul Rhode & Koleman Strumpf, 2006. "Manipulating political stock markets: A field experiment and a century of observational data," Natural Field Experiments 00325, The Field Experiments Website.
  4. RYan Oprea & David Porter & Chris Hibbert & Robin Hanson & Dorina Tila, 2008. "Can Manipulators Mislead Prediction Market Observers?," Working Papers 08-01, Chapman University, Economic Science Institute.
  5. Justin Wolfers & Eric Zitzewitz, 2006. "Interpreting Prediction Market Prices as Probabilities," NBER Working Papers 12200, National Bureau of Economic Research, Inc.
  6. Charles F. Manski, 2004. "Interpreting the Predictions of Prediction Markets," NBER Working Papers 10359, National Bureau of Economic Research, Inc.

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