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Prediction markets also known as predictive markets , information markets , decision markets , idea futures , event derivatives , or virtual markets are exchange-traded markets created for the purpose of trading the outcome of events. The market prices can indicate what the crowd thinks the probability of the event is.
Prediction markets can be thought of as belonging to the more general concept of crowdsourcing which is specially designed to aggregate information on particular topics of interest. The main purposes of prediction markets are eliciting aggregating beliefs over an unknown future outcome.
Traders with different beliefs trade on contracts whose payoffs are related to the unknown future outcome and the market prices of the contracts are considered as the aggregated belief. Before the era of scientific polling, early forms of prediction markets often existed in the form of political betting.
One such political betting can date back to , where people would bet on who will be the papal successor. Economic theory for the ideas behind prediction markets can be credited to Friedrich Hayek in his article " The Use of Knowledge in Society " and Ludwig von Mises in his " Economic Calculation in the Socialist Commonwealth ". Modern economists agree that Mises' argument combined with Hayek's elaboration of it, is correct .
The journal was first published in , and is available online and in print. The ability of the prediction market to aggregate information and make accurate predictions is based on the Efficient Market Hypothesis , which states that assets prices are fully reflecting all available information. For instance, existing share prices always include all the relevant related information for the stock market to make accurate predictions.
Surowiecki raises 3 necessary conditions for collective wisdom: The market itself has a character of decentralization compared to expertise decisions. Because of these reasons, predictive market is generally a valuable source to capture collective wisdom and make accurate predictions.
Prediction markets have an advantage over other forms of forecasts due to the following characteristics. Next, they obtain truthful and relevant information through financial and other forms of incentives. Prediction markets can incorporate new information quickly and are difficult to manipulate.
The accuracy of the prediction market in different conditions has been studied and proven by numerous researchers. Due to the accuracy of the prediction market, it has been applied to different industries to make important decisions.
Although prediction markets are often fairly accurate and successful, there are many times the market fails in making the right prediction or making one at all. However, this information gathering technique can also lead to the failure of the prediction market.
Oftentimes, the people in these crowds are skewed in their independent judgements due to peer pressure, panic, bias, and other breakdowns developed out of a lack of diversity of opinion. One of the main constraints and limits of the wisdom of crowds is that some prediction questions require specialized knowledge that majority of people do not have. The second market mechanism is the idea of the marginal-trader hypothesis.
The method is built off the idea of taking confidence into account when evaluating the accuracy of an answer. The method asks people two things for each question: What they think the right answer is, and what they think popular opinion will be.
The variation between the two aggregate responses indicates the correct answer. The effects of manipulation and biases are also internal challenges prediction markets need to deal with, i. Prediction markets may also be subject to speculative bubbles. There can also be direct attempts to manipulate such markets. In the Tradesports presidential markets there was an apparent manipulation effort.
An anonymous trader sold short so many Bush presidential futures contracts that the price was driven to zero, implying a zero percent chance that Bush would win. The only rational purpose of such a trade would be an attempt to manipulate the market in a strategy called a " bear raid ".
If this was a deliberate manipulation effort it failed, however, as the price of the contract rebounded rapidly to its previous level. As more press attention is paid to prediction markets, it is likely that more groups will be motivated to manipulate them.
However, in practice, such attempts at manipulation have always proven to be very short lived. In their paper entitled "Information Aggregation and Manipulation in an Experimental Market" ,  Hanson, Oprea and Porter George Mason U , show how attempts at market manipulation can in fact end up increasing the accuracy of the market because they provide that much more profit incentive to bet against the manipulator.
Using real-money prediction market contracts as a form of insurance can also affect the price of the contract. For example, if the election of a leader is perceived as negatively impacting the economy, traders may buy shares of that leader being elected, as a hedge.
These prediction market inaccuracies were especially prevalent during Brexit and the US Presidential Elections. Even until the moment votes were counted, prediction markets leaned heavily on the side of staying in the EU and failed to predict the outcomes of the vote. According to Michael Traugott , a former president of the American Association for Public Opinion Research , the reason for the failure of the prediction markets is due to the influence of manipulation and bias shadowed by mass opinion and public opinion.
Similarly, during the US Presidential Elections, prediction markets failed to predict the outcome, throwing the world into mass shock. Because online gambling is outlawed in the United States through federal laws and many state laws as well, most prediction markets that target US users operate with "play money" rather than "real money": Notable exceptions are the Iowa Electronic Markets , which is operated by the University of Iowa under the cover of a no-action letter from the Commodity Futures Trading Commission , and PredictIt , which is operated by Victoria University of Wellington under cover of a similar no-action letter.
Some kinds of prediction markets may create controversial incentives. For example, a market predicting the death of a world leader might be quite useful for those whose activities are strongly related to this leader's policies, but it also might turn into an assassination market. A combinatorial prediction market is a type of prediction market where participants can make bets on combinations of outcomes. One difficulty of combinatorial prediction markets is that the number of possible combinatorial trades scales exponentially with the number of normal trades.
These exponentially large data structures can be too large for a computer to keep track of, so there have been efforts to develop algorithms and rules to make the data more tractable. Since , decentralized platforms for prediction markets have been in development. These platforms utilize blockchain technology and cryptocurrencies to provide various advantages over centralized markets, but also more challenges for regulators.
Some advantages of decentralized prediction markets are as follows: Some risks associated with decentralized prediction markets are as follows: From Wikipedia, the free encyclopedia. This article has multiple issues. Please help improve it or discuss these issues on the talk page. Learn how and when to remove these template messages. This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed.
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