Prediction Markets: the Collective Knowledge of Market Participants

Prediction Markets: The Collective Knowledge of Market Participants Justin Wolters Associate Professor ofBusiness and Public Policy Wharton School, University of Pennsylvania Philadelphia Prediction markets provide an information-aggregation technology applicable to a variety of topics, including political and financial risk. Because of the human idiosyncrasiesidentifiedbybehavioralfinance, predictionmarkets canfail, buthistorical data show them to be as accurate as traditional polling methodologies and far less expensive to establish and maintain. n this discussion, I will make three substantive Sports Prediction Markets. Interestingly, I claims about prediction markets. First, if mar sportsbetting markets manifest manyof the charac kets really are efficient, as the efficient market teristics expected of an efficient market, and they hypothesis asserts/then the prices that come out of now allow participants to trade stock during the any market contain valuable information. To make gameonthelikelihoodofa particularteamwinning. the case for this claim, I will use data from sports For example, Figure 1 shows real-time betting dur betting markets. Second, prediction markets can be ing Game 6 ofthe 2003 NationalLeague Champion used to trackpoliticalrisk, whichcanbe a keyfactor ship Series (NLCS). This prediction market from driving investment performance. Third, prediction Intrade pays $1 ifand only ifthe Chicago Cubs win . markets can fail, so I will conclude my discussion this particular game. At the beginning of the game, by describing why prediction markets work and itlooks as ifthe Cubshave abouta 75 percentchance what causes them to fail. of winning. In the top ofthe eighthinning, the Cubs go ahead of the Florida Marlins 3-D, and the chance Prediction Markets and the of the Cubs winning the game and going to the World Series reaches 95 percent. Unfortunately, in Efficient Market Hypothesis the bottom of that same inning, one of the great e efficient market hypothesis asserts that market collapsesinsportinghistoryoccurred. A fan reaches prices fully reflect available information. But the out from the stands and prevents a catch by Cubs degree to whichinformationis available determines outfielder Moises Alou. The Marlins proceed to theform inwhichthe hypothesis reveals itself. Inits score eight runs in that inning, and the market strong form, prices reflect all information; in its responds immediately to this new information. In a 'semi-strong form, prices reflect all publicly avail matter ofminutes, the marketprice declines from 95 able information; in its weak form, prices reflect cents to about 5 cents. Only past data. In anyone of these forms, however, The questionmoreimportantthanwhetherpre rices can reflect, summarize, and aggregate a huge diction markets respond quickly to news, though, is ount of information, but the unfortunate impli- whetherthese marketpricesareaccurate. To answer ation of the hypothesis is that excess returns are that question, I have charted data from alI 21,885 predictable. Thus, prices can be said to follow a major league baseball games played from 1991 andomwalk. through 2000, and the data show that the predic tions are quite close to the actual outcomes. For is presentation comes from the 2008 CFA Institute Annual Confer instance, if the market says a team has a 33 percent held in Vancouver, British Columbia, Canada, on 11-14May2008. chance ofwinning, it actualIywins 31 percent ofthe 2009 CFA Institute • cfapubs.org JUNE 2009 • 37 CFA Institute Conference Proceedings Quarterly Figure 1. Real·Time Betting on the Chicago Cubs: 2003 NLCS, Game 6 Price ($) 1.00 ,------------------;:--------, ~Io.-~--- Fan Spoils Alou's Catch 0.80 Top of the 8th Iruting 0.60 0.40 0.20 o 8:05p.m. 9:00p.m. !0:00p.m. 11:00 p.m. Note: Time is given in central (Chicago) time. Source: Based on data from Intrade. time. When the market says a team has a 67 percent ingtake, whichare, again, quite accurate. Therefore, chance of winning, it wins 65 percent of the time, an analyst covering the movie industry may find and when the market says a team has a 90 percent these forecasts quite useful, which means that such chance of winning, it wins 88 percent of the time. an exchange moves us toward the realm of socially The difference is how Las Vegas makes money. But useful prediction markets. the real point is that if a person wants accurate For instance, Deutsche Bank and Goldman information on the likely outcomes of baseball Sachs briefly started a new market (now folded, games, the betting odds do an excellent job of pro viding that information. unfortunately) that they called the "economic The same point holds true for other sports. For derivatives market." It allowed investors to trade example, based on market expectations and game on thefuture outcomes ofparticulareconomicindi outcomes for the National Football League from cators, such as retail sales and business confidence. 1984 to 2000 (Le., for 3,791 games), a regression The economic derivatives market provided fore analysis shows a slope of almost 1.0 (0.997 to be casts for nonfarm payrolls, initial unemployment exact). Thus, when the market says that a team is claims, retail sales, and business confidence, and likely to win and gives a margin of a prespecified based on data thatRefet Giirkaynak andI gathered, number ofpoints (the "pointspread"), thatteam, on these forecasts were more accurate than an average average, wins by the point spread. or consensus forecast of 35 economists. Donot, however,thinkofthesefindings as mere My conclusion, therefore, is that rather than conversation topics. Rather, think of prediction averaging theforecasts of35economists, thosesame markets as a technology that can be used to aggre economists should be put in a room and told to bet gate opinions about anything of importance. or trade against each other. Taking the rnarket Socially Useful Prediction Markets. Consider aggregated price from this tradingwouldprovide a the firm called the Hollywood Stock Exchange. It more efficient way of aggregating forecasts. The runs prediction markets on the opening weekend task, then, is to harness this technology to more box office take of various movies. Essentially, it challengingissues. One suchissueis politics. Infact, allows people to trade, or bet, on how well each prediction markets have been used quite exten movie will perform. Data from that market can sively to predict political risk, which is a key factor show the aggregated forecast and the actual open- driving investment performance. 38 • JUNE 2009 ©2009 CFA Institute • cfapubs.arg r " Prediction Markets Prediction Markets and Political therefore, represent a valuable gain in accuracy and a significant reduction in costs. Risk il Results from recent cycles. In the 2004 U.S. In2003, a recall electionwas held to remove Califor election cycle, investors cou1d trade not only which nia Governor Gray Davis from office and replace candidate wou1d become president but also who him with one of several contenders, one of whom wou1d win the Electoral College votes ofeach state. was Arnold Schwarzenegger. Prediction markets Based on data from Intrade, the prediction market allowed people to trade on the question of whether price accurately predicted every state that went for Schwarzenegger would win the governorship. A George W. Bush and every state that went against contract paying $100 if Schwarzenegger won could him. For the 2004 U.S. Senate races, theIntrade price be traded on two exchanges-Intrade, which is was correct for every state but Alaska. In the 2006 based in Ireland, or the World Sports Exchange, election cycle, most knowledgeable observers and which is based in the Caribbean. Attempts to recall many Republicans did not expect the Democrats to other governors had occurred in California, but win enough seats to gain the majority in the Senate. none had been successful. Nevertheless, I set my But every Single Senate race went exactly the way computer to look for arbitrage opportunities the election-eve prediction market said it wou1d. between Intrade and the World Sports Exchange. ii1 History ofpolitical prediction markets. Such Every four hours, my computer checked these two predictionmarkets seemlike a marvelous new tech websites and searched for potential profits. By the nologyfor forecasting electionresu1ts, butas itturns end of the exercise, I had made no money, but I had out,betting onpolitics is as oldas politicsitself. Two learned an important research lesson. When I fol enterprising economic historians-Rhode and lowed the chart of the two exchange prices, the bid Strumpf-have gathered data on the amount ofbet price in one market was never above the asking ting that has occurred on U.S. presidential elections price inthe other, whichmeans thatthe twomarkets from 1884 through 1928. Opinion polling did not are closely linked. The price pattern that we are so exist in any systematic or nationwide manner at the familiar with in other financial markets appears to time, butbetting on elections occurred regu1arly on hold true for poli.tical prediction markets. the curb where the American Stock Exchange now stands. In fact, large sums of money were traded. Accuracy of Political Prediction Markets. For the 1884-1928 period, an average of $37 million These markets have a tremendous historical record. (in 2002 dollars) was bet per election, which turns In 1988, facu1ty from the University ofIowa created out to be a $2.28 bet per vote and the equivalent of a trading market now called the Iowa Electronic 54 percent of total campaign spending. By using Markets. This market has followed hundreds of archival data, one can follow the performance of elections in the United States and elsewhere, so an political prediction markets for well over 100 years. extensive record exists to chart its predictive accu In fact, in a comparison of the election-eve pre racy. Except for a few misses, the predicted outcome dictionmarketsfor 1880 through2004 withtheactual and the actual outcome of most elections converge results, once again, the prediction markets accu along the same line. rately indicated-with two exceptions-whether a Considerinparticu1ar theU.5.

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