ABSTRACT
For prediction markets having asset prices between $0 and $100, prices should translate directly into probabilities. That is, if the price is $25, then the probability of the contract expiring at $100 should be 25 percent.1 But, surprisingly, price itself determines a considerable degree of mispricing. Wolfers and Zitzewitz (2006) show that in the Iowa Electronic Markets, prices significantly deviate from values within certain price bands. Specifically, contract win rates are lower (higher) than expected, around $25 ($75). In other words, sellers (buyers) are net winners for trades occurring at prices around $25 ($75). This pattern can be explained by the utility-maximizing behavior of traders. For prediction markets having a $0-$100 asset pricing format, and for constant relative risk aversion (CRRA) between 0 and 1, an equilibrium occurs in which price is between the market’s mean subjective valuation and $50.2 The result is that contracts costing less (more) than $50 may be overpriced (underpriced).
