Liquidity and Prediction Market Efficiency

Abstract

I investigate the relationship between liquidity and market efficiency using data from short horizon binary outcome securities listed on the TradeSports exchange. I find that liquidity does not reduce, and sometimes increases, deviations of prices from financial and sporting event outcomes. One explanation is that limit order traders are naïve about other traders' knowledge and unwittingly bet against them, which can slow the response of prices to information. Consistent with this explanation, the limit orders that execute during informative time periods have negative expected returns; and limit orders often execute against traders who exploit the well-known favorite-longshot bias in prices.

Keywords: Liquidity, Underreaction, Market Efficiency, Prediction Markets, Limits to Arbitrage, Prospect Theory

JEL Classification: G10, G12, G14