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The Extent of Price Misalignment in Prediction Markets

19 Pages Posted: 27 May 2014  

David M. Rothschild

Microsoft Research - NYC

David M. Pennock

Microsoft Corporation - Microsoft Research, New York City

Date Written: May 26, 2014

Abstract

We study misaligned prices for logically related contracts in prediction markets. First, we uncover persistent arbitrage opportunities for risk-neutral investors between identical contracts on different exchanges. Examining the impact of several thousand dollars of transactions on the exchanges themselves in a randomized field trial, we document that price support extends well beyond what is seen in the published order book and that arbitrage opportunities are significantly larger than purely observational measurements indicate. Second, we demonstrate misalignment among identical and logically related contracts listed on the same exchange that cluster around moments of high information flow, when related contracts systemically shut down or fail to respond efficiently. Third, we document bounded rationality in prediction markets; examples include: consistent asymmetry between buying and selling, leaving the average return for selling higher than for buying; and persistent price lags between exchanges. Despite these signs of departure from theoretical optimality, the markets studied function well on balance, considering the sometimes complex and subtle relationships among contracts. Yet, we detail how to improve prediction markets by moving the burden of finding and fixing logical contradictions into the exchange and providing flexible trading interfaces, both of which free traders to focus on providing meaningful information in the form they find most natural.

Suggested Citation

Rothschild, David M. and Pennock, David M., The Extent of Price Misalignment in Prediction Markets (May 26, 2014). Algorithmic Finance 2014, 3:1-2, 3-20. Available at SSRN: https://ssrn.com/abstract=2441816

David Rothschild (Contact Author)

Microsoft Research - NYC ( email )

641 6th Ave., 7th Floor
New York, NY 10011
United States

David Pennock

Microsoft Corporation - Microsoft Research, New York City ( email )

641 Avenue of Americas
New York, NY 10011
United States

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