Many complex concepts in finance are not understood by the general population and prediction markets are one example. The purpose of this blogpost will be to discuss the various characteristics of a prediction market and provide you with resources to learn further about this type of future contract. Outside of one course taught by Dr. Koleman Strumpf at the University of Kansas, prediction markets are not taught in business schools across America.
A prediction market is a version of a futures market in which the payoff depends on the potential outcomes of future events. For example, a market might be created with the question, “What seed will KU receive in the NCAA tournament?” Participants in the market can then bet on whether KU will be assigned a 1,2,3, or 4 or lower seed by the NCAA tournament selection committee. Suppose when the market opens, probability of KU receiving a #1 seed is 25%, and you purchase a contract worth $25. If KU ends up receiving a #1 seed, you will receive $100 because there is a 100% chance the Jayhawks will have a #1 seed going into the tournament.
Even if you don’t understand how prediction markets function, it is important to realize the ends for which these markets can be used. Primarily, prediction markets are used to aggregate information and harness the “wisdom of crowds”. Companies can use prediction markets to accurately forecast future events. Participants in prediction markets are usually driven by the motivation of profits. This profit incentive leads individuals to do research before purchasing contract. Therefore, the generated information is generally accurate.
In his book The Wisdom of Crowds, James Surowieki wrote about prediction markets and opportunities to harness the wisdom of crowds to make decisions. Standard contracts in prediction markets are based on binary events in which something either will or will not happen. Contracts can be written unknown future events in sports, business, politics, and basically everything in between. The price a trader is willing to pay can be thought of as the probability an event will occur. For instance, if a participants in a political prediction market collectively believe that President Obama has a 50% chance of being re-elected, the price of purchasing a contract for the President’s successful re-election will be $50.
If you’d like to know more about prediction markets, you can read James Surowieki’s book The Wisdom of Crowds and read this blogpost from GeekCity.
Here's a selection of popular online prediction markets:
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