Aggregation of Information and Beliefs in Prediction Markets

Marco Ottaviani and Peter Sørensen

No 2007/01, FRU Working Papers from University of Copenhagen. Department of Economics. Finance Research Unit

Abstract: We analyze a binary prediction market in which traders have heterogeneous prior beliefs and private information. Realistically, we assume that traders are allowed to invest a limited amount of money (or have decreasing absolute risk aversion). We show that the rational expectations equilibrium price underreacts to information. When favorable information to an event is available and is revealed by the market, the price increases and this forces optimists to reduce the number of assets they can (or want to) buy. For the market to equilibrate, the price must increase less than a posterior belief of an outside observer.

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: 26 pages
Date: 2007-05
New Economics Papers: this item is included in nep-mst
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Citations: View citations in EconPapers (5)

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