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Risk Aversion, Beliefs, and Prediction Market Equilibrium

  • Steven Gjerstad

    (University of Arizona)

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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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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  1. 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.
  2. Manski, Charles F., 2006. "Interpreting the predictions of prediction markets," Economics Letters, Elsevier, vol. 91(3), pages 425-429, June.
  3. 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.
  4. Plott, Charles R. & Wit, J. & Yang, W. C., 1997. "Parimutuel Betting Markets as Information Aggregation Devises: Experimental Results," Working Papers 986, California Institute of Technology, Division of the Humanities and Social Sciences.
  5. 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.
  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. 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.
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