Interpreting Prediction Market Prices

William Wilson and Philip Wallach argue that prediction market prices are often misinterpreted:

the prices do not represent the binary “win or lose” probabilities of a Clinton return to 1600 Pennsylvania. The clearing price for Clinton commodity speculation was $2.20; with two years until the election, as many people as not believe that at any future time the universe of TS bettors will pay more than $2.20 for her stock. Sure, some of these Clinton speculators may believe that her chances of winning the ‘08 election are better than 22%, but many of them may have also believed that near-term news cycles would be more favorable to her than not, or that the Democratic swell on November 7 would raise all Democrats’ chances relative to Republican ones. And for every one of those traders, a paired trader has speculated the opposite to an inversely proportional degree (i.e., someone was also willing to pay $7.80 to make $10 for the proposition that Hillary would not become President in ‘08). The beauty of Tradesports—what differentiates it from a simple sportsbook—is that it allows such speculation; no one must hold a contract until expiration. The “odds-speak” shorthand conveys the right price, but shouldn’t suggest an inappropriately probabilistic explanation of January 20, 2009.

posted on 28 November 2006 by skirchner in Economics, Financial Markets

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