Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

Marco Ottaviani and Peter Sørensen

No 09-14, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: In a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price is demonstrated to underreact to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first period price is followed by momentum.

Keywords: prediction markets; private information; heterogeneous prior beliefs; limited budget; underreaction (search for similar items in EconPapers)
JEL-codes: D82 D83 D84 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2009-07
New Economics Papers: this item is included in nep-cta
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Citations: View citations in EconPapers (8)

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Persistent link: https://EconPapers.repec.org/RePEc:kud:kuiedp:0914

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