The extent of price misalignment in prediction markets

Abstract

We study misaligned prices for logically related contracts in prediction markets. First, we uncover persistent arbitrage opportunities for risk-neutral investors between identical contracts on different exchanges. Examining the impact of several thousand dollars of transactions on the exchanges themselves in a randomized field trial, we document that price support extends well beyond what is seen in the published order book and that arbitrage opportunities are significantly larger than purely observational measurements indicate. Second, we demonstrate misalignment among identical and logically related contracts listed on the same exchange that cluster around moments of high information flow, when related contracts systemically shut down or fail to respond efficiently. Third, we document bounded rationality in prediction markets; examples include: consistent asymmetry between buying and selling, leaving the average return for selling higher than for buying; and persistent price lags between exchanges. Despite these signs of departure from theoretical optimality, the markets studied function well on balance, considering the sometimes complex and subtle relationships among contracts. Yet, we detail how to improve prediction markets by moving the burden of finding and fixing logical contradictions into the exchange and providing flexible trading interfaces, both of which free traders to focus on providing meaningful information in the form they find most natural.

Classification of intraday S&P500 returns with a Random Forest

“…A central aspect for financial markets, including prediction markets, is information efficiency, which refers to the fact that information is incorporated in and reflected by a price, and that no market participant is able to influence the market price directly (Vaughan Williams & Reade, 2016). However, prediction markets also show irrationality and anomalies that are common for other financial markets, such as price misalignments (Rothschild & Pennock, 2014) and the tendency to overweight low-probability events and underweight events that are almost certain to occur (Wolfers & Zitzewitz, 2004). Consequently, prediction markets show many parallels to financial stock markets.…”

Integrating Market Makers, Limit Orders, and Continuous Trade in Prediction Markets

“…If feasible, one might constrain the payout to always be zero. Various objectives can be layered on top of the constraints to select a particular order fill: maximizing volume, maximizing value to the traders (according to their limit prices), and so on [Rothschild and Pennock 2014]. Agrawal et al [2011] propose a sophisticated convex program where the eventual payout is controlled by both a subsidy and a loss function over any amounts the subsidy does not cover.…”

Arbitrage in Political Prediction Markets

“…An important form of (and the weakest condition for) market efficiency (Rhode and Strumpf, 2004;Rothschild and Pennock, 2014), arbitrage, has been underexplored (Luckner and Weinhardt, 2008;Kildalet al, 2012). In markets where arbitrage opportunities cannot be exploited, the interpretation of prices as probability measures can become problematic (Wolfers and Zitzewitz, 2004; Table 1.…”