Prediction Markets

Table of Contents

Prediction Markets 2

Corporate Prediction Markets 3

Corporate Prediction Markets Applications 4

Practical Examples 6

Challenges of Prediction Markets 7

Designing Prediction Markets 8

Conclusion 8

Bibliography 9

Appendix: Application of Prediction Markets at Google, Ford and Firm X 10

The objective of this paper is to explore the effectiveness of predictions markets and determine the potential use of prediction markets for strategic corporate decision-making.

Prediction Markets

Arrow et al (2008) describe predictions markets as “forums for trading contracts that yield payments based on the outcome of uncertain events”. To illustrate with an example, the Iowa Electronic Market prior to the US presidential election in 2012, allowed traders to sell and purchase contracts that paid $1, if a given candidate (i.e. either Barak Obama or Mitt Romney) won the election. The contracts relating to each candidate were being sold at a different price between traders.

Economic theory suggests that information is scattered across various economic actors. In this context a market or mechanism that can aggregate all the information is desirable (Arrow et all 2008). Prediction markets aggregate information, as different economic actors trade contracts based on their knowledge and information. Therefore, the prices of contracts being traded reflect aggregated market knowledge. The price of the contract is then the best estimate of all parameters required to estimate the probability of the outcome of a particular contract, as it reflect complete information. For example, if the price of the contract tied to an Obama victory is 60 pence, and the price of the contract tied to a Romney victory if 30 pence. The higher price of the first contract suggests the market predicts an Obama victory.

Cynics would criticise the economic theories above, stating that in the real world the underlying assumptions of rational investors (i.e. investor know how to...