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The cost of capital in a prediction market

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  • Grant, Andrew
  • Johnstone, David
  • Kwon, Oh Kang

Abstract

Prediction markets are financial markets that are crystalized by simplicity and rigor. We extend the analogy between capital markets and prediction markets by considering the “cost of capital” in a prediction market. A typical prediction market contract pays either $1 or zero at expiry, and a gambler-cum-investor attaches a subjective probability p to the contract expiring “in the money”. We consider how the gambler’s “discount rate”, or required rate of return, responds to changes in p. By applying utility theory or asset pricing theory, we find that risk-averse gamblers discount any contract with a high subjective probability of success (including the payoff from “shorting” a longshot) less heavily than a contract with a low probability, or longshot. This finding reveals a simple, rational explanation for the favorite-longshot bias.

Suggested Citation

  • Grant, Andrew & Johnstone, David & Kwon, Oh Kang, 2019. "The cost of capital in a prediction market," International Journal of Forecasting, Elsevier, vol. 35(1), pages 313-320.
    • Handle: RePEc:eee:intfor:v:35:y:2019:i:1:p:313-320
    DOI: 10.1016/j.ijforecast.2018.04.004
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