Interpreting Prediction Market Prices as Probabilities

24 Pages Posted: 2 Aug 2006

See all articles by Justin Wolfers

Justin Wolfers

University of Michigan at Ann Arbor - Department of Economics; University of Michigan at Ann Arbor - Gerald R. Ford School of Public Policy; The University of Sydney - Discipline of Economics; Brookings Institution - Economic Studies Program; Peterson Institute for International Economics; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); Kiel Institute for the World Economy

Eric Zitzewitz

Dartmouth College; NBER

Multiple version iconThere are 3 versions of this paper

Date Written: May 2006

Abstract

While most empirical analysis of prediction markets treats prices of binary options as predictions of the probability of future events, Manski (2004) has recently argued that there is little existing theory supporting this practice. We provide relevant analytic foundations, describing sufficient conditions under which prediction markets prices correspond with mean beliefs. Beyond these specific sufficient conditions, we show that for a broad class of models prediction market prices are usually close to the mean beliefs of traders. The key parameters driving trading behavior in prediction markets are the degree of risk aversion and the distribution of beliefs, and we provide some novel data on the distribution on beliefs in a couple of interesting contexts. We find that prediction markets prices typically provide useful (albeit sometimes biased) estimates of average beliefs about the probability an event occurs.

Keywords: Binary option, event future, futures, information market, Manski and options

JEL Classification: D4, D8, G13

Suggested Citation

Wolfers, Justin and Zitzewitz, Eric W., Interpreting Prediction Market Prices as Probabilities (May 2006). CEPR Discussion Paper No. 5676, Available at SSRN: https://ssrn.com/abstract=921642

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