Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

41 Pages Posted: 13 Aug 2009

See all articles by Marco Ottaviani

Marco Ottaviani

Bocconi University - Department of Economics

Peter Norman Sorensen

University of Copenhagen - Department of Economics

Date Written: August 11, 2009

Abstract

In a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price is demonstrated to underreact to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first period price is followed by momentum.

Keywords: prediction markets, private information, heterogeneous prior beliefs, limited budget, underreaction

JEL Classification: D82, D83, D84

Suggested Citation

Ottaviani, Marco and Sorensen, Peter Norman, Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets (August 11, 2009). University of Copenhagen Department of Economics Discussion Paper No. 09-14, Available at SSRN: https://ssrn.com/abstract=1447369 or http://dx.doi.org/10.2139/ssrn.1447369

Marco Ottaviani

Bocconi University - Department of Economics ( email )

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Peter Norman Sorensen (Contact Author)

University of Copenhagen - Department of Economics ( email )

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