Implications of Belief Distribution and Loss Aversion for Betting Market Anomalies

Abstract

The past several decades have witnessed a growing enthusiasm to implement the market as an information aggregation tool. However, some deep-rooted pricing anomalies frequently observed in various markets loom large, questioning the rationality of such eagerness. One of these anomalies is the favorite-longshot bias, and sometimes its opposite, the reverse favorite-longshot bias. We propose an equilibrium model consisting of traders with cumulative prospect theory-based utility and heterogeneous beliefs to explain these two anomalies in a unified framework. Unlike existing results that mostly focus on one aspect of the underlying model, our model enables us to isolate and analyze the impact of probability weighting, loss aversion, belief concentration, and belief tailedness. We show how these parameters jointly determine the property of the equilibrium price. Empirical results also suggest this model has adequate flexibility to explain the behavior of actual historical data.

Keywords: Forecasting; Belief aggregation; Market anomalies; Prediction markets; Prospect Theory