Arbitrage and Market Efficiency in Sports Betting Markets Bachelor
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Arbitrage and Market Efficiency in Sports Betting Markets Bachelor Thesis Rob Clowting 10071881 Economie & Bedrijfskunde Finance & Organization Supervisor: P. Versijp 07-02-2014 Abstract Section Page Introduction 1 Literature and Background 2 Methodology 7 Results 9 Practical application of arbitrage betting 12 Conclusion and Discussion 15 Appendix 16 Reference List 16 1 Introduction Arbitrage is defined as the simultaneous purchase and sale of the same security in two different markets for different prices with a risk free return. In modern financial markets this mispricing is increasingly difficult to exploit for individual investors, but in the market for online sports betting recent literature suggests arbitrage may arise frequently and in an easily expolitable way. The online sports betting market has grown enormously over the past decade due to the rise of the internet and mobile internet devices allowing bettors to place bets on any sports event, at any time, anywhere in the world. According to Bwin.Party, one of the leading global online betting agencies, the global online sports betting market, excluding the US, was estimated to be worth €10.5 billion in 2012 and expected to grow at 7.3% per year for the period 2012-2015 (Bwin.Party, 2013). The market for online sports betting is divided into two seperate markets. The first and best known is the bookmakers market, where individual bettors bet on sports events where the odds have been determined by the bookmakers preferences and information. The other market, which is relatively younger and less well known, is the exchange market, where odds/prices are determined by supply and demand of individual bettors. In this market, bettors can not only bet on a certain outcome "Team X wins/draws/loses", but also against these outcomes, giving "Team X does not win/draw/lose". This exchange market can be approached in the same way as a normal stock market, with the opportunity to go long (bet on a certain outcome) and to go short (bet against a certain outcome). In the difference in odds between these two markets that arise due to bookmaker preferences and other factors, the literature suggests that arbitrage opportunities arise frequently. Franck, Verbeek and Nüensch (2012) researched the five big European football leauges for arbitrage opportunities, and suggested that for smaller leaugues different results may arise due to different levels of market efficiency. To research this question, this paper will investigate the Dutch Eredivisie in the season 2012-2013 and research the arbitrage frequency and returns. These results will be compared to the results found by Franck, Verbeek and Nüensch to see if there are any significant differences. 1 Literature and Background One of the most important concepts in modern day finance is the Law of One Price (Lamont and Thaler, 2003). This law states that an identical good must sell for identical prices in all markets. Theoretically, if this law is violated, meaning an identical asset is sold for different prices on different markets, an arbitrage opportunity arises. The concept of arbitrage is generally defined as the simultaneous purchase and sale of the same asset to profit from a price difference. Arbitrage is a crucial concept in modern day financial theory. Because arbitrageurs instantly exploit the arisen arbitrage opportunities, prices theoretically never fluctuate far from equilibirum for extensive periods of time. The arbitrageurs make a small riskless profit and prices are quickly back at effiecient levels. This is the basis of modern day financial theory such as Fama's classical efficient market theory, the CAPM model and Ross's Arbitrage Pricing Theory (Schleifer and Vishny, 1997). In their paper on anomalies in the Law of One Price, Lamont and Thaler (2003) suggest that this Law might be violated on a larger scale than economists expect. A famous example is the mispricing of Royal Dutch/Shell, where shares for the firm were supposed to be traded at a 1.5 ratio in two different markets (London and Amsterdam), but this ratio varied from being 30 percent too low to 15 percent too high. This example, amongst others, is a blatant violation of the Law of One Price and together with bubbles on financial markets there seems to be evidence that other factors, still unknown to academics, may be influencing prices in financial markets (Lamont and Thaler, 2003). Arbitrageurs exploit price inefficiencies in a market to make a riskless profit. By doing so they also rebalance the price to its equilibrium, because the exploitation of arbitrage opportunities leads to prices changing back to their efficient level. In modern financial markets, arbitrage opportunities often arise and disappear in a matter of nanoseconds and complicated software and trading systems are required to exploit these. In online betting markets, recent studies performed by amongst others Vlastakis et al. (2009) and Franck et al. (2012) show that arbitrage opportunities arise frequently and in an easily exploitable way. 2 Betting markets are interesting for academic research because they function similar to normal financial markets (Vlastakis et al., 2009). Academic literature has focused on market efficiency in betting markets because it allows for easy testing compared to financial markets. The advantage of conducting research on betting markets is that bets have a period of life that is certain beforehand and the resulting value of the bet is fully known afterwards. This paper will research the extent to which betting market efficiency varies over differently sized leagues in European football betting. Inefficiency and mispricing in betting markets has been researched quite extensively. Inefficiency in betting markets implies that the odds given by the bookmaker or market do not reflect the true probabilities of an outcome. Papers on this subject often research biases in bookmaker pricesetting, such as the favourite-longshot bias, as described by Vlastakis et al. (2009). The favourite-longshot bias states that betting on favourites (low returns with high probability) yields higher average returns than betting on longshots (high returns with low probability). This bias has been consistently proven in many different sports, ranging from american football in the United States and regular football (soccer) in Europe to horse racing. Another bias found by several papers on the subject and described by Vlastakis et al. (2009) is the overestimation of the home team advantage. Because bettors tend to have a statistically unjustified bias towards the home team, bookmakers set their odds inefficiently to exploit this biased betting behaviour. The reasoning behind this will be explained in the next section. Vlastakis et al. (2009) find that the most profitable strategy is betting on 'away-favourites', where it should be remarked that this strategy still has a negative average return. To answer the question why bookmakers set prices inefficiently the literature agrees on several causes. One reason, as given by Vlastakis et al. (2009), Kuypers (2000) and Franck et al. (2012) can be found in human psychology. Bookmakers set inefficient odds but maximize profits by exploiting bettor biases over a certain sports event. For example, a bookmaker with a strong presence or customer base in England may expolit sentimental betting over an England national football team game against Germany. By setting inefficient odds the bookmaker may still maximize its profit by exploiting the 3 potentially irrational betting behaviour of its English customers. The loss they take on their inefficient odds is compensated by higher trading volume. A second reason for inefficient pricesetting, also described by Vlastakis et al. (2009), is that bookmakers want to exploit the 'favourite-longshot' and 'home advantage' biases. For example, if the team that is in first place in a league plays against the team that is in last place, a bookmaker may set odds for the team in last place to win higher than they should be, attracting more bettors that take a 'long shot' on this outcome. Again, the higher betting volume compensates the mispricing, maximizing profit for the bookmaker. Another simple but important reason, described by Franck et al. (2012), is that bookmakers purposefully set their odds inefficiently for advertisement or promotional reasons. By offering odds that give short term negative returns for the bookmaker during the promotion or advertisent period, the bookmaker hopes to attract new customers that will stick to their company and give postive net returns in the long run. To understand how bookmakers can compensate mispricing with betting volume we look at the bookmaker's revenue model. The bookmaker earns its money by charging a commission that is integrated in its odds. This implies that a fraction of every bet a bettor makes goes directly to the bookmaker as a commission. Franck et al. (2012) find that bookmakers charge 11.3% commission on average. This gives rise to the opportunity for bookmakers to set odds inefficiently to boost betting volume. Because they charge a commission on all bets, high betting volumes have the potential to compensate losses taken on mispricing. This mispricing should potentially give rise to arbitrage opportunities. Vlastakis et al. (2009) researched arbitrage in the bookmaker market by itself, also called intra-market arbitrage. Arbitrage opportunities are found by spreading bets across multiple bookmakers that have different odds for the same match. They found that arbitrage opportunities arise in only 0,5% of matches. To examine potential arbitrage between the bookmakers market and the exchange market first the betting exchange market will be examined. Betting exchange markets are relatively new in the online sports betting world. The best known and largest betting exchange platform is Betfair, with almost 1 million active 4 users worldwide and an annual revenue of £387 million in 2013 (Betfair, 2014). In a betting exchange market, the bookmakers are completely replaced and prices are set by a constant auction process of supply and demand of odds, determined by individual bettors themselves.