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Prediction Markets: Tapping the Wisdom of Crowds Yiling Chen Yahoo! Research February 3, 2008
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NYU Stern 2/3/20082 Outline Introduction to prediction markets What is a prediction market? Functions of markets Contracts and mechanisms Prediction market examples Iowa Electronic Markets Yahoo! Tech Buzz Game Looking forward Decision markets Combinatorial markets
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NYU Stern 2/3/20083 Events of Interest Will Giants win the Super Bowl? Will Hillary Clinton win the Democratic Primary race? Will Democratic party win the Presidential election? Will (Should) Microsoft and Yahoo merge? Will US economy go into recession during 2008? Will there be a cure for cancer by 2015? Will sales value exceed $200k in April? ……
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NYU Stern 2/3/20084 Bet = Credible Opinion Q: Will Giants win the Super Bowl? Betting intermediaries Las Vegas, Wall Street, Betfair, Intrade,... Giants will win the Super Bowl. Info I bet $1000 Patriots will win the Super Bowl. Info
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NYU Stern 2/3/20085 Prediction Markets A prediction market is a financial market that is designed for information aggregation and prediction. Payoffs of the traded item is associated with outcomes of future events.
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NYU Stern 2/3/20086 Prediction Markets A prediction market is a financial market that is designed for information aggregation and prediction. Payoffs of the traded item is associated with outcomes of future events. $1 if Clinton Wins $0 Otherwise
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NYU Stern 2/3/20087 Prediction Markets A prediction market is a financial market that is designed for information aggregation and prediction. Payoffs of the traded item is associated with outcomes of future events. $1 if Clinton Wins $0 Otherwise $1×Percentage of Vote Share That Clinton Wins
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NYU Stern 2/3/20088 Prediction Markets A prediction market is a financial market that is designed for information aggregation and prediction. Payoffs of the traded item is associated with outcomes of future events. $1 if Clinton Wins $0 Otherwise $1×Percentage of Vote Share That Clinton Wins $1 if Patriots win $0 Otherwise
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NYU Stern 2/3/20089 Prediction Markets A prediction market is a financial market that is designed for information aggregation and prediction. Payoffs of the traded item is associated with outcomes of future events. $1 if Clinton Wins $0 Otherwise $1×Percentage of Vote Share That Clinton Wins $1 if Patriots win $0 Otherwise $f(x)
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NYU Stern 2/3/200810 Prediction Market 1, 2, 3 Turn an uncertain event of interest into a random variable Hillary Clinton wins election? (Y/N) => 1/0 random variable. Create a financial contract, payoff = value of the random variable Open a market in the financial contract and attract traders to wager and speculate $1 if Hillary Clinton wins election $0 otherwise
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NYU Stern 2/3/200811 Terminology Contract, security, contingent claim, stock, derivatives (futures, options), bet, gamble, wager, lottery Key aspect: payoff is uncertain Prediction markets, information markets, virtual stock markets, decision markets, betting markets, contingent claim markets Historically mixed reputation, but can serve important social roles
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NYU Stern 2/3/200812 http://intrade.com Screen capture 2008/02/02 Bird Flu Market
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NYU Stern 2/3/200813 http://intrade.com Screen capture 2008/02/02 Search Engine Market Shares
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NYU Stern 2/3/200814 Super Bowl Markets
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NYU Stern 2/3/200815 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies)
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NYU Stern 2/3/200816 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200817 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) Value of Contract ? $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200818 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) Value of Contract Payoff Event Outcome $1 $0 Patriots win Patriots lose ? $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200819 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) Value of Contract Payoff Event Outcome P( Patriots win ) 1- P( Patriots win ) $1 $0 Patriots win Patriots lose ? $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200820 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) Value of Contract Payoff Event Outcome $P( Patriots win ) P( Patriots win ) 1- P( Patriots win ) $1 $0 Patriots win Patriots lose $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200821 Function of Markets 1: Get Information price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) Value of Contract Payoff Event Outcome $P( Patriots win ) P( Patriots win ) 1- P( Patriots win ) $1 $0 Patriots win Patriots lose Equilibrium Price Value of Contract P( Patriots Win ) Market Efficiency $1 if Patriots win, $0 otherwise
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NYU Stern 2/3/200822 Non-Market Alternatives vs. Markets Opinion poll Sampling No incentive to be truthful Equally weighted information Hard to be real-time Ask Experts Identifying experts can be hard Incentives Combining opinions can be difficult Prediction Markets Self-selection Monetary incentive and more Money-weighted information Real-time Self-organizing
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NYU Stern 2/3/200823 Non-Market Alternatives vs. Markets Machine learning/Statistics Historical data Past and future are related Hard to incorporate recent new information Prediction Markets No need for data No assumption on past and future Immediately incorporate new information
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NYU Stern 2/3/200824 Function of Markets 2: Risk Management If is terrible to me, I buy a bunch of If my house is struck by lightening, I am compensated. $1 if $0 otherwise
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NYU Stern 2/3/200825 Risk Management Examples Insurance I buy car insurance to hedge the risk of accident Futures Farmers sell soybean futures to hedge the risk of price drop Options Investors buy options to hedge the risk of stock price changes
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NYU Stern 2/3/200826 Financial Markets vs. Prediction Markets Financial MarketsPrediction Markets PrimarySocial welfare (trade) Hedging risk Information aggregation SecondaryInformation aggregationSocial welfare (trade) Hedging risk
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NYU Stern 2/3/200827 Does it work? Yes, evidence from real markets, laboratory experiments, and theory Racetrack odds beat track experts [Figlewski 1979] Orange Juice futures improve weather forecast [Roll 1984] I.E.M. beat political polls 451/596 [Forsythe 1992, 1999][Oliven 1995][Rietz 1998][Berg 2001][Pennock 2002] HP market beat sales forecast 6/8 [Plott 2000] Sports betting markets provide accurate forecasts of game outcomes [Gandar 1998][Thaler 1988][Debnath EC’03][Schmidt 2002] Market games work [Servan-Schreiber 2004][Pennock 2001] Laboratory experiments confirm information aggregation [Plott 1982;1988;1997][Forsythe 1990][Chen, EC’01] Theory: “rational expectations” [Grossman 1981][Lucas 1972] and more …
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NYU Stern 2/3/200828 An Incomplete List of Prediction Markets Real Money Iowa Electronic Markets (IEM), http://www.biz.uiowa.edu/iem/http://www.biz.uiowa.edu/iem/ TradeSports, http://www.tradesports.comhttp://www.tradesports.com InTrade, http://www.intrade.comhttp://www.intrade.com Betfair, http://www.betfair.com/http://www.betfair.com/ Gambling markets? sports betting, horse racetrack … Play Money Hollywood Stock Exchange (HXS), http://www.hsx.com/http://www.hsx.com/ NewsFutures, http://www.newsfutures.comhttp://www.newsfutures.com Yahoo!/O’REILLY Tech Buzz Game, http://buzz.research.yahoo.comhttp://buzz.research.yahoo.com World Sports Exchange (WSE), http://www.wsex.com/http://www.wsex.com/ Foresight Exchange, http://www.ideosphere.com/http://www.ideosphere.com/ Inkling Markets http://inklingmarkets.com/http://inklingmarkets.com/ Internal Prediction Markets HP, Google, Microsoft, Eli-Lilly, Corning …
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NYU Stern 2/3/200829 Contracts and Mechanisms What is being traded? the “good” Define: Random variable Payoff function Payoff output How is it traded? the “mechanism” Call market Continuous double auction Continuous double auction w/ market maker Pari-mutuel market Bookmaker Combinatorial Automated market maker
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NYU Stern 2/3/200830 Contracts Random variables (Questions to ask) Binary, Discrete Tomorrow or Sales revenue $200k Continuous interest rate, temperature, vote share … Clarity “Clinton wins” “Saddam out”
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NYU Stern 2/3/200831 Contracts Payoff functions Winner-takes-all (Arrow-Debreu) Index, continuous Dividend, pari-mutuel, option: max[0, s-k], arbitrary function Payoff output Real money, play money, prize, lottery $1 if $1 vote share
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NYU Stern 2/3/200832 Call Market and CDA Call market Stock market mechanism before 1800 Orders are collected over a period of time; collected orders are matched at end of period Price is set such that demand=supply Continuous double auction (CDA) Current stock market mechanism Buy and sell orders continuously come in As soon as bid ask, a transaction occurs IEM, TradeSports, NewsFutures
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NYU Stern 2/3/200833 CDA with Market Maker Same as CDA, but with a market maker A market maker is an extremely active, high volume trader (often institutionally affiliated) who is nearly always willing to buy at some price p and sell at some price q ≥ p Market maker essentially sets prices; others take it or leave it Market maker bears risk, increases liquidity HXS, WSE
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NYU Stern 2/3/200834 Pari-Mutuel Market E.g. horse racetrack style wagering Two outcomes: A B Wagers: AB [Source: Pennock]
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NYU Stern 2/3/200835 AB Pari-Mutuel Market E.g. horse racetrack style wagering Two outcomes: A B Wagers: [Source: Pennock]
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NYU Stern 2/3/200836 AB Pari-Mutuel Market E.g. horse racetrack style wagering Two outcomes: A B Wagers: [Source: Pennock]
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NYU Stern 2/3/200837 Bookmaker Common in sports betting, e.g. Las Vegas Bookmaker is like a market maker in a CDA Bookmaker sets “money line”, or the amount you have to risk to win $100 (favorites), or the amount you win by risking $100 (underdogs) Bookmaker makes adjustments considering amount bet on each side &/or subjective prob’s Alternative: bookmaker sets “game line”, or number of points the favored team has to win the game by in order for a bet on the favorite to win; line is set such that the bet is roughly a 50/50 proposition
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NYU Stern 2/3/200838 Outline Introduction to prediction markets What is a prediction market? Functions of markets Contracts and mechanisms Prediction market examples Iowa Electronic Markets Yahoo! Tech Buzz Game Looking forward Decision markets Combinatorial markets
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NYU Stern 2/3/200839 Iowa Electronic Markets (IEM) http://www.biz.uiowa.edu/iem 2008 U.S. Presidential Democratic Nomination Markets $1 if Hillary Clinton wins $1 if John Edwards wins $1 if Barack Obama wins $1 if “other” wins [source: http://iemweb.biz.uiowa.edu/graphs/graph_DConv08.cfm, as of 2/2/08]http://iemweb.biz.uiowa.edu/graphs/graph_DConv08.cfm
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NYU Stern 2/3/200840 IEM Winner Takes All Market $1 if Democrat votes > Repub $1 if Republican votes > Dem price=E[R]=Pr(R)=0.415 [Source: http://www.biz.uiowa.edu/iem/, as of 2/2/08] http://www.biz.uiowa.edu/iem/ 2008 US Presidential Election WTA Market
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NYU Stern 2/3/200841 IEM Vote Share Market $1 vote share of Dem $1 vote share of Repub price=E[VS of Repub]=48.8% [Source: http://www.biz.uiowa.edu/iem/, as of 2/2/08] http://www.biz.uiowa.edu/iem/ 2008 US Presidential Election Vote Share Market
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NYU Stern 2/3/200842 IEM 1992 [Source: Berg, DARPA Workshop, 2002]
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NYU Stern 2/3/200843 Example: IEM [Source: Berg, DARPA Workshop, 2002]
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NYU Stern 2/3/200844 Example: IEM [Source: Berg, DARPA Workshop, 2002]
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NYU Stern 2/3/200845 Tech Buzz Game Yahoo!,O’Reilly launched Buzz Game 3/05 @ETech Research testbed for investigating prediction markets Buy “stock” in hundreds of technologies Earn dividends based on search “buzz” at Yahoo! Search Mechanism: dynamic pari-mutuel market http://buzz.research.yahoo.com
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NYU Stern 2/3/200846 Technology Forecasts iPod phone Another Apple unveiling 10/12; iPod Video search buzz price 9/8-9/18: searches for iPod phone soar; early buyers profit 8/29: Apple invites press to “secret” unveiling 8/28: buzz gamers begin bidding up iPod phone 9/7: Apple announces Rokr 9am 10/5
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NYU Stern 2/3/200847 Tech Buzz Game Performance Based on data from 9/29/05 to 1/27/06, 175 stocks in 44 markets
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NYU Stern 2/3/200848 Outline Introduction to prediction markets What is a prediction market? Functions of markets Contracts and mechanisms Prediction market examples Iowa Electronic Markets Yahoo! Tech Buzz Game Looking forward Decision markets Combinatorial markets
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NYU Stern 2/3/200849 Predicting the CEO Will Mr. Smith or Ms. Jones be the CEO of company X? $1 if Ms. Jones becomes CEO $1 if Mr. Smith becomes CEO Pr(Mr. Smith) Pr(Ms. Jones) $1
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NYU Stern 2/3/200850 Predicting CEO Outcomes How will CEO affect stock prices? Alternatively, $1 if Mr. Smith becomes CEO & stock price goes up $1 if Mr. Smith becomes CEO & stock price goes down $1 if Ms. Jones becomes CEO & stock price goes down $1 if Ms. Jones becomes CEO & stock price goes up 1 share of stock, if Mr. Smith becomes CEO 1 share of stock, if Ms. Jones becomes CEO
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NYU Stern 2/3/200851 CEO Decision Market Should company X hire Mr. Smith or Ms. Jones as CEO? $1 if Mr. Smith becomes CEO Pr(stock up|Mr. Smith) Pr(Ms. Jones) $1 $1 if Ms. Jones becomes CEO $1 if Mr. Smith becomes CEO & stock price goes up $1 if Ms. Jones becomes CEO & stock price goes up Pr(Mr. Smith) Pr(stock up|Ms. Jones) Which one is higher? Pr(stock up|Mr. Smith)=Pr(Mr. Smith & Stock up)/Pr(Mr. Smith)
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NYU Stern 2/3/200852 CEO Decision Market Conditional market $1 if stock price goes up and Mr. Smith becomes CEO $0 if stock price goes down and Mr. Smith becomes CEO called off if Mr. Smith does not become CEO $1 if stock price goes up | Mr. Smith becomes CEO $1 if stock price goes up | Mr. Jones becomes CEO
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NYU Stern 2/3/200853 Decision Markets Give E(O|C) C hoices FED money policy Next president Health care regulation School vouchers Who is CEO Which ad agency O utcomes GDP per capita War deaths Lifespan School test scores Stock price Product sales [Source: Hanson]
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NYU Stern 2/3/200854 http://intrade.com Screen capture 2008/02/02 Election Decision Markets
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NYU Stern 2/3/200855 A Combinatorics Example March Madness
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NYU Stern 2/3/200856 A Combinatorics Example March Madness
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NYU Stern 2/3/200857 A Combinatorics Example March Madness
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NYU Stern 2/3/200858 Combinatorics Example March Madness Typical today Non-combinatorial Team wins Rnd 1 Team wins Tourney A few other “props” Everything explicit (By def, small #) Every bet independent: Ignores logical & probabilistic relationships Combinatorial Any property Team wins Rnd k Duke > {UNC,NCST} ACC wins 5 games 2 2 64 possible props (implicitly defined) A bet effects related bets “correctly”; e.g., to enforce logical constraints
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NYU Stern 2/3/200859 Expressiveness: Getting Information Things you can say today: (>43% chance that) Hillary wins GOP wins Texas YHOO stock > 30 Feb. 2008 Duke wins NCAA tourney Things you can’t say (very well) today: Oil down, DOW up, & Hillary wins Hillary wins election, given that she wins OH & FL YHOO btw 25.8 & 32.5 Feb. 2008 No. 1 seed in NCAA tourney win more than No. 2 seed
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NYU Stern 2/3/200860 Expressiveness: Processing Information Independent markets today: Horse race win, place, & show pools Stock options at different strike prices Every game/proposition in NCAA tourney Almost everything: Stocks, wagers, intrade,... Information flow (inference) left up to traders Better Let traders focus on predicting whatever they want, however they want. Mechanism takes care of logical/probabilistic inference
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NYU Stern 2/3/200861 Combinatorial Markets Single-elimination tournament betting (Bracketology) Team A wins round 5 Team A beats team B given that they meet Permutation style betting Horse A beats horse B Horse A finishes at position 1, 2, or 5 Boolean style betting Oil price decreases & Democrat wins election & Number of US Troop in Iraq decreases & …
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