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It takes all sorts: a heterogeneous agent explanation for prediction market mispricing

It takes all sorts: a heterogeneous agent explanation for prediction market mispricing
It takes all sorts: a heterogeneous agent explanation for prediction market mispricing
Pricing anomalies threaten the value of prediction markets as a means of harnessing the ’wisdom of the crowd’ to make accurate forecasts. The most persistent and puzzling pricing anomaly associated with price-implied prediction probabilities is the favourite-longshot bias (FLB). We demonstrate that existing models of the FLB fail to capture its full complexity, thereby preventing appropriate adjustments to market forecasts to improve their accuracy. We develop an agent-based model with heterogeneous agents in a fixed-odds market. Our agent-based simulations and comprehensive analysis using market data demonstrate that our model explains real market behaviour, including that of market makers, better than existing theories. Importantly, our results suggest that adequately complex models are necessary to describe complex phenomena such as pricing anomalies. We discuss how our model can be used to better understand the relation between market ecology and mispricing in contexts such as options and prediction markets, consequently enhancing their predictive power.
0377-2217
556-569
Restocchi, Valerio
39654f4e-2a84-4c78-a853-081704568415
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Gerding, Enrico
d9e92ee5-1a8c-4467-a689-8363e7743362
Johnson, Johnnie E.V.
6d9f1a51-38a8-4011-a792-bfc82040fac4
Restocchi, Valerio
39654f4e-2a84-4c78-a853-081704568415
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Gerding, Enrico
d9e92ee5-1a8c-4467-a689-8363e7743362
Johnson, Johnnie E.V.
6d9f1a51-38a8-4011-a792-bfc82040fac4

Restocchi, Valerio, McGroarty, Frank, Gerding, Enrico and Johnson, Johnnie E.V. (2018) It takes all sorts: a heterogeneous agent explanation for prediction market mispricing. European Journal of Operational Research, 270 (2), 556-569. (doi:10.1016/j.ejor.2018.04.011).

Record type: Article

Abstract

Pricing anomalies threaten the value of prediction markets as a means of harnessing the ’wisdom of the crowd’ to make accurate forecasts. The most persistent and puzzling pricing anomaly associated with price-implied prediction probabilities is the favourite-longshot bias (FLB). We demonstrate that existing models of the FLB fail to capture its full complexity, thereby preventing appropriate adjustments to market forecasts to improve their accuracy. We develop an agent-based model with heterogeneous agents in a fixed-odds market. Our agent-based simulations and comprehensive analysis using market data demonstrate that our model explains real market behaviour, including that of market makers, better than existing theories. Importantly, our results suggest that adequately complex models are necessary to describe complex phenomena such as pricing anomalies. We discuss how our model can be used to better understand the relation between market ecology and mispricing in contexts such as options and prediction markets, consequently enhancing their predictive power.

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Submitted date: 26 March 2018
Accepted/In Press date: 12 April 2018
e-pub ahead of print date: 12 April 2018
Published date: 16 October 2018

Identifiers

Local EPrints ID: 419718
URI: http://eprints.soton.ac.uk/id/eprint/419718
ISSN: 0377-2217
PURE UUID: 497b461e-0389-41e6-8438-e53ad661bebf
ORCID for Frank McGroarty: ORCID iD orcid.org/0000-0003-2962-0927
ORCID for Enrico Gerding: ORCID iD orcid.org/0000-0001-7200-552X

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Date deposited: 20 Apr 2018 16:30
Last modified: 26 Mar 2020 05:01

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Contributors

Author: Valerio Restocchi
Author: Frank McGroarty ORCID iD
Author: Enrico Gerding ORCID iD

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