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Prediction Markets: Tapping the Wisdom of Crowds. Yiling Chen Yahoo! Research February 3, 2008. Outline. Introduction to prediction markets What is a prediction market? Functions of markets Contracts and mechanisms Prediction market examples Iowa Electronic Markets

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## Prediction Markets: Tapping the Wisdom of Crowds

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**Prediction Markets: Tapping the Wisdom of Crowds**Yiling Chen Yahoo! Research February 3, 2008**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 NYU Stern 2/3/2008**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? …… NYU Stern 2/3/2008**Info**Info I bet $1000 Patriots will win the Super Bowl. Giants will win the Super Bowl. Bet = Credible Opinion • Q: Will Giants win the Super Bowl? • Betting intermediaries • Las Vegas, Wall Street, Betfair, Intrade,... NYU Stern 2/3/2008**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. NYU Stern 2/3/2008**$1 if Clinton Wins**$0 Otherwise 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. NYU Stern 2/3/2008**$1 if Clinton Wins**$0 Otherwise 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×Percentage of Vote Share That Clinton Wins NYU Stern 2/3/2008**$1 if Clinton Wins**$0 Otherwise $1 if Patriots win $0 Otherwise 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×Percentage of Vote Share That Clinton Wins NYU Stern 2/3/2008**$1 if Clinton Wins**$0 Otherwise $1 if Patriots win $0 Otherwise 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×Percentage of Vote Share That Clinton Wins $f(x) NYU Stern 2/3/2008**$1 if Hillary Clinton wins election**$0 otherwise 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 NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**Bird Flu Market**http://intrade.com Screen capture 2008/02/02 NYU Stern 2/3/2008**Search Engine Market Shares**http://intrade.com Screen capture 2008/02/02 NYU Stern 2/3/2008**Super Bowl Markets**NYU Stern 2/3/2008**Function of Markets 1: Get Information**• price expectation of r.v. | all information (in theory, lab experiments, and empirical studies) NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**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 Value of Contract ? NYU Stern 2/3/2008**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 Event Outcome Value of Contract Payoff $1 Patriots win ? $0 Patriots lose NYU Stern 2/3/2008**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 Event Outcome Value of Contract Payoff P( Patriots win ) $1 Patriots win ? 1- P( Patriots win ) $0 Patriots lose NYU Stern 2/3/2008**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 Event Outcome Value of Contract Payoff P( Patriots win ) $1 Patriots win $P( Patriots win ) 1- P( Patriots win ) $0 Patriots lose NYU Stern 2/3/2008**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 Event Outcome Value of Contract Payoff P( Patriots win ) $1 Patriots win $P( Patriots win ) 1- P( Patriots win ) $0 Patriots lose Equilibrium Price Value of Contract P( Patriots Win ) Market Efficiency NYU Stern 2/3/2008**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 Non-Market Alternatives vs. Markets NYU Stern 2/3/2008**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 Non-Market Alternatives vs. Markets NYU Stern 2/3/2008**$1 if $0 otherwise**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. NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**Financial Markets vs. Prediction Markets**NYU Stern 2/3/2008**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 … NYU Stern 2/3/2008**An Incomplete List of Prediction Markets**• Real Money • Iowa Electronic Markets (IEM), http://www.biz.uiowa.edu/iem/ • TradeSports, http://www.tradesports.com • InTrade, http://www.intrade.com • Betfair, http://www.betfair.com/ • Gambling markets? sports betting, horse racetrack … • Play Money • Hollywood Stock Exchange (HXS), http://www.hsx.com/ • NewsFutures, http://www.newsfutures.com • Yahoo!/O’REILLY Tech Buzz Game, http://buzz.research.yahoo.com • World Sports Exchange (WSE), http://www.wsex.com/ • Foresight Exchange, http://www.ideosphere.com/ • Inkling Markets http://inklingmarkets.com/ • Internal Prediction Markets • HP, Google, Microsoft, Eli-Lilly, Corning … NYU Stern 2/3/2008**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 Contracts and Mechanisms NYU Stern 2/3/2008**Contracts**• Random variables (Questions to ask) • Binary, Discrete • Tomorrow or • Sales revenue < $100k, $100k - $200k, >$200k • Continuous • interest rate, temperature, vote share … • Clarity • “Clinton wins” • “Saddam out” NYU Stern 2/3/2008**$1 if**$1 vote share 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 NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**A**B Pari-Mutuel Market • E.g. horse racetrack style wagering • Two outcomes: A B • Wagers: [Source: Pennock] NYU Stern 2/3/2008**A**B Pari-Mutuel Market • E.g. horse racetrack style wagering • Two outcomes: A B • Wagers: [Source: Pennock] NYU Stern 2/3/2008**A**B Pari-Mutuel Market • E.g. horse racetrack style wagering • Two outcomes: A B • Wagers: [Source: Pennock] NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**Iowa Electronic Markets (IEM)**http://www.biz.uiowa.edu/iem 2008 U.S. Presidential Democratic Nomination Markets $1 if Hillary Clinton wins $1 if Barack Obama wins $1 if “other” wins $1 if John Edwards wins [source: http://iemweb.biz.uiowa.edu/graphs/graph_DConv08.cfm, as of 2/2/08] NYU Stern 2/3/2008**IEM Winner Takes All Market**2008 US Presidential Election WTA 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] NYU Stern 2/3/2008**IEM Vote Share Market**2008 US Presidential Election 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] NYU Stern 2/3/2008**[Source: Berg, DARPA Workshop, 2002]**IEM 1992 NYU Stern 2/3/2008**[Source: Berg, DARPA Workshop, 2002]**Example: IEM NYU Stern 2/3/2008**[Source: Berg, DARPA Workshop, 2002]**Example: IEM NYU Stern 2/3/2008**Tech Buzz Game**http://buzz.research.yahoo.com • 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 NYU Stern 2/3/2008**iPod phone**Another Apple unveiling 10/12; iPod Video 8/28: buzz gamersbegin biddingup iPod phone 9/7: AppleannouncesRokr 8/29: Appleinvites pressto “secret”unveiling 9/8-9/18: searchesfor iPod phone soar;early buyers profit 9am 10/5 Technology Forecasts price searchbuzz NYU Stern 2/3/2008**Tech Buzz Game Performance**Based on data from 9/29/05 to 1/27/06, 175 stocks in 44 markets NYU Stern 2/3/2008**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 NYU Stern 2/3/2008**Predicting the CEO**• Will Mr. Smith or Ms. Jones be the CEO of company X? $1 if Mr. Smith becomes CEO Pr(Mr. Smith) $1 Pr(Ms. Jones) $1 if Ms. Jones becomes CEO NYU Stern 2/3/2008**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 up $1 if Ms. Jones becomes CEO & stock price goes down 1 share of stock, if Mr. Smith becomes CEO 1 share of stock, if Ms. Jones becomes CEO NYU Stern 2/3/2008

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