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Prediction market prices under risk aversion and heterogeneous beliefs
Institution:1. University of Technology Sydney, Business School, Finance Discipline Group, Australia;2. Toulouse School of Economics, INRA, University Toulouse Capitole, France;1. Department of Economics, Bar-Ilan University, Ramat-Gan 52900, Israel;2. Department of Economics, Ben-Gurion University, Beer-Sheva 84105, Israel;3. Department of Economics and Business, Aarhus University, 8210 Aarhus, Denmark;4. CESifo, Poschingerstrasse 5, 81679 Munich, Germany;5. IZA, Schaumburg-Lippe Strasse 7/9, 53113 Bonn, Germany;1. Center of Economic Research at ETH Zurich (CER-ETH), Switzerland;2. Department of Economics, Maastricht University, Netherlands;1. IPAG Business School, 184 boulevard Saint-Germain, 75006 Paris, France;2. Department of Economics, Ecole Polytechnique, Paris, France;3. CREA, Université du Luxembourg, 162A avenue de la Faïencerie, L-1511 Luxembourg, Luxembourg;1. IPAG Business School, CEREMADE, Université Paris-Dauphine, Pl. du maréchal de Lattre de Tassigny, 75775 Paris Cedex 16, France;2. IPAG Business School, CNRS, PSE, VCREME, CES, 106-112 Bd de l’Hôpital, 75647 Paris Cedex 13, France
Abstract:In this paper, we examine the properties of prediction market prices when risk averse traders have heterogeneous beliefs in state probabilities. We show that the equilibrium state prices equal the mean beliefs of traders about that state if and only if the traders’ common utility function is logarithmic. We also provide a necessary and sufficient condition ensuring that the state prices are systematically below or above the mean beliefs of traders, thus providing a rational explanation to the favorite-longshot bias in prediction markets.
Keywords:Prediction market  Heterogeneous beliefs  Risk aversion  Favorite-longshot bias
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