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The cost of capital in a prediction market

Andrew Grant, David Johnstone and Oh Kang Kwon

International Journal of Forecasting, 2019, vol. 35, issue 1, 313-320

Abstract: Prediction markets are financial markets that are crystalized by simplicity and rigor. We extend the analogy between capital markets and prediction markets by considering the “cost of capital” in a prediction market. A typical prediction market contract pays either $1 or zero at expiry, and a gambler-cum-investor attaches a subjective probability p to the contract expiring “in the money”. We consider how the gambler’s “discount rate”, or required rate of return, responds to changes in p. By applying utility theory or asset pricing theory, we find that risk-averse gamblers discount any contract with a high subjective probability of success (including the payoff from “shorting” a longshot) less heavily than a contract with a low probability, or longshot. This finding reveals a simple, rational explanation for the favorite-longshot bias.

Keywords: Prediction markets; Cost of capital; Favorite-longshot bias (search for similar items in EconPapers)
Date: 2019
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