Prediction Markets 101
How can we effectively aggregate the “wisdom of the crowd” ?
The answer is prediction markets.
A prediction market is a market where people can trade contracts with a payoff based on the outcomes of unknown but clearly defined future events. The market prices generated from these contracts can be understood as a kind of collective prediction among market participants. These prices are based on individual expectations and the willingness of investors to put their money on the line for those expectations.
Prediction markets can be used as a way to estimate the perceived probability of future events as well as correlations and more complex relationships between them. The have been used to forecast events ranging from spread of pandemics, election outcomes and the success probability of projects (along more simple but equally exciting events in finance and sports).
In its most common form, a prediction market is similar to a financial market for binary outcome events. People can buy and sell predictions about a particular event occurring, e.g. X candidate winning the election. An example will help to clarify the prediction market concept: consider a contract that pays $1 if Candidate X wins the presidential election. If the market price of an X contract is currently 66 cents, this means that the candidate is 66% likely to win the election. If a trader buys $1 at this price and the candidate wins the election, that share will be paid out at $1.5 (1/0.66), yielding a profit of 50 cents. On the other hand, if the candidate loses the election, the same share will cost $0 and the trader will have lost $1. In figure 1 we can see the candidates X and Y probabilities through time based on the trading in the prediction market. Obviously, probabilities always add up to 100%, and the probability of Y candidate equals 1- the probability of X candidate.
The efficient market hypothesis is a term that is used mainly in financial economics, arguing that asset prices indicate all available information. According to the efficient market hypothesis (EMH), there is no room to take advantage of market prices, as everything is fairly priced. Prediction markets, like financial markets, drive the community to seek better information and act on that knowledge, boosting their chances of outperforming other participants. Think of prediction markets as a system that can be used to aggregate opinions about anything of importance. Prediction markets are successful because of the information that is accessible and dispersed within the crowd of participants drives them via clear financial incentives to converge prices to fair levels. These fair levels should represent the best available probability assessment of an event at any given time.
The Iowa Electronic Market (IEM), an experiment in market-based forecasting operated by teachers at the University of Iowa’s Tippie School of Business, is one of the forerunners of online prediction markets. More accurately than traditional opinion surveys over the long run, IEM traders have been able to predict the results of presidential elections using real money.
The above chart shows data from past U.S. presidential elections. In the horizontal axis we can see the remaining days until the election. The vertical axis measures the average absolute deviation between the shares linked with the two parties and actual vote shares gained in the election.
In a corporate context, the Hollywood Stock Exchange predicts opening weekend box office earnings in USD millions and the chart below shows that the forecasted earnings are pretty close to the actual ones. Moreover, this market has been quite accurate at forecasting Oscar winners as compared with a panel of experts.
Some firms have also begun to experiment with internal prediction markets. An internal market at Hewlett-Packard produced more accurate forecasts of printer sales than the firm’s internal processes. An experiment at Siemens in which an internal market predicted that the firm would definitely fail to deliver on a software project on time, even when traditional planning tools suggested that the deadline could be met.
There are a number of mechanisms of price discovery in prediction markets:
- Continuous Double Action (CDA): connecting buyers and sellers of shares exactly like a a stock market. In the case of prediction markets, bets on specific outcomes can be purchased or sold, with the price changing based on whether the outcome is perceived to be more or less likely. In order to send the payout to the eventual owner of each wager, the prediction market operator must keep track of every trade in a ledger.
- Decentralized exchanges (DEXs), which were developed to do away with all middlemen in the trading of crypto assets, include automated market makers (AMM) . These protocols use smart contracts, a type of self-executing computer code, to establish the price of cryptocurrency tokens and offer liquidity. You can make trades using the AMM protocol without the assistance of another trader. Instead, you may use a smart contract for trading. AMM aids in creating a system of liquidity that anyone can fund. In the case of prediction markets the participants buy and sell yes/no shares.
In a centralized prediction market, the entire market is governed and controlled by one central entity. This indicates that the placing of prediction events, choosing which events players can participate plus overseeing of the centrally custodied funds and payouts are all under the control of this organisation. Finally that centralised organisation can participate in the market and take positions.
A decentralized prediction market eliminates the need for a central authority to carry out these functions. Instead, thousands of users, whose activity and reporting validates results, keep the market’s integrity. By connecting the market to a trustless immutable blockchain , the integrity of the market is also preserved. Smart contracts can be used to ensure that all right payments occur automatically at the appropriate times via oracles or other robust methods. Decentralised prediction markets are more global, open, free, and independent of any one individual or business and are the best implementation of this market innovation.
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