Prediction Market

HSX

Betfair

Prediction markets are speculative markets created for the purpose of making predictions; the current market prices can then be interpreted as predictions of the probability of the event or the expected value of the parameter. For example, a prediction market security might reward a dollar if a particular candidate is elected, such that an individual who thinks the candidate had a 70% chance of being elected should be willing to pay up to 70 cents for such a security.

People who buy low and sell high are rewarded for improving the market prediction, while those who buy high and sell low are punished for degrading the market prediction. Evidence so far suggests that prediction markets are at least as accurate as other institutions predicting the same events with a similar pool of participants.

Prediction markets have a long and colorful lineage. Betting on elections was common in the U.S. until at least the 1940s, with formal markets existing on Wall Street in the months leading up to the race. Newspapers reported market conditions to give a sense of the closeness of the contest in this period prior to widespread polling. The markets involved thousands of participants, had millions of dollars in volume in current terms, and had remarkable predictive accuracy.

One of the oldest and most famous prediction markets is the University of Iowa’s ‘Iowa Electronic Market.’ Around 1990 at Project Xanadu (an Internet technology research organization), Robin Hanson used the first known corporate prediction market. Employees used it in order to bet on, for example, the cold fusion controversy. The Hollywood Stock Exchange is a virtual market game established in 1996 and now a division of financial services firm Cantor Fitzgerald. Players buy and sell prediction shares of movies, actors, directors, and film-related options. HedgeStreet, designated in 1991 as a market and regulated by the Commodity Futures Trading Commission, enables Internet traders to speculate on economic events. In 2003, the U.S. Department of Defense publicized a ‘Policy Analysis Market’ and on their website speculated that additional topics for markets might include terrorist attacks. A critical backlash quickly denounced the program as a ‘terrorism futures market’ and the Pentagon hastily canceled the program.

Prediction markets are championed in American journalist James Surowiecki’s 2004 book ‘The Wisdom of Crowds,’ legal scholar Cass Sunstein’s 2006 ‘Infotopia,’ and ‘How to Measure Anything: Finding the Value of Intangibles in Business’ by risk management expert Douglas Hubbard. The research literature is collected together in the peer reviewed ‘The Journal of Prediction Markets,’ published by the University of Buckingham Press. The journal was first published in 2007, and is available online and in print. Some academic research has focused on potential flaws with the prediction market concept. In particular, Dr. Charles F. Manski of Northwestern University published ‘Interpreting the Predictions of Prediction Markets,’ which attempts to show mathematically that under a wide range of assumptions the ‘predictions’ of such markets do not closely correspond to the actual probability in question. Manski suggests that directly asking a group of participants to estimate probabilities may lead to better results.

A common belief among economists and the financial community in general is that prediction markets based on play money cannot possibly generate credible predictions. However, the data collected so far disagrees. Analyzed data from the Hollywood Stock Exchange and the Foresight Exchange concluded that market prices predicted actual outcomes and/or outcome frequencies in the real world. Comparing an entire season’s worth of NFL predictions from NewsFutures’ play-money exchange to those of Tradesports, an equivalent real-money exchange based in Ireland, both exchanges performed equally well. In this case, using real money did not lead to better predictions. Hollywood Stock Exchange creator Max Keiser suggests that not only are these markets no more predictive than their established counterparts such as the New York Stock Exchange and the London Stock Exchange, but that reducing the unpredictability of markets would mean reducing risk and, therefore, reducing the amount of speculative capital needed to keep markets open and liquid.

Prediction markets suffer from the same types of inaccuracy as other kinds of market, i.e. liquidity (an asset’s ability to be sold without causing a significant movement in the price) or other factors not intended to be measured are taken into account as risk factors by the market participants, distorting the market probabilities. Prediction markets may also be subject to speculative bubbles. For example, in the year 2000 IEM presidential futures markets, seeming ‘inaccuracy’ comes from buying that occurred on or after Election Day ’00, but, by then, the trend was clear.

There can also be direct attempts to manipulate such markets. In the Tradesports 2004 presidential markets there was an apparent manipulation effort. An anonymous trader sold short so many Bush 2004 presidential futures contracts that the price was driven to zero, implying a zero percent chance that Bush would win. The only rational purpose of such a trade would be an attempt to manipulate the market in a strategy called a ‘bear raid.’ If this was a deliberate manipulation effort it failed, however, as the price of the contract rebounded rapidly to its previous level. As more press attention is paid to prediction markets, it is likely that more groups will be motivated to manipulate them.

However, in practice, such attempts at manipulation have always proven to be very short lived. In their paper entitled ‘Information Aggregation and Manipulation in an Experimental Market’ (2005), Hanson, Oprea, and Porter show how attempts at market manipulation can in fact end up increasing the accuracy of the market because they provide that much more profit incentive to bet against the manipulator. Using real-money prediction market contracts as a form of insurance can also affect the price of the contract. For example, if the election of a leader is perceived as negatively impacting the economy, traders may buy shares of that leader being elected, as a form of insurance.

Because online gambling is outlawed in the United States through federal laws and many state laws as well, most prediction markets that target U.S. users operate with ‘play money’ rather than ‘real money’: they are free to play (no purchase necessary) and usually offer prizes to the best traders as incentives to participate. Notable exceptions are Intrade/TradeSports, which escapes U.S. legal restrictions by operating from Dublin, Ireland, where gambling is legal and regulated, and the Iowa Electronic Markets, which operates from the University of Iowa under the cover of a no-action letter from the Commodity Futures Trading Commission and allows bets up to $500. Some kinds of prediction markets may create controversial incentives. For example, a market predicting the death of a world leader might be quite useful for those whose activities are strongly related to this leader’s policies, but it also might turn into an assassination market.

The simExchange introduced a perpetual contract that it calls ‘stocks’ to predict the global, lifetime sales of video game consoles and software titles. These stocks do not expire like most contracts on prediction markets because the founder, Brian Shiau, argued that video game sales can continue for years. The premise for these stocks is that Shiau believes the video game industry suffers from a ‘lack of comprehensive sales data’ and he compares the information problem of a game’s sales to the information problem of evaluating a company’s market value. Hanson warns that such a system may not work if a connection is not enforced. Keith Gamble has described the simExchange as a Keynesian beauty contest and that financial markets have certain remedies such as company buy-outs that cannot happen on the simExchange. Gamble concludes that such a prediction market can work but will be confined to play money.

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