# In as long as mation Markets John Ledyard April 13, 2005 Nancy Schwartz Memorial Lecture

## In as long as mation Markets John Ledyard April 13, 2005 Nancy Schwartz Memorial Lecture

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How would it work Familiar Question: Who will win an election St in addition to ard approach – Polls. In 1988, University of Iowa Business School securitized the Presidential election prediction on the internet. The Iowa Election Market In 1992, as long as \$1.00, Iowa sold or bought a set of securities that covered all possible outcomes of the election; Bush, Clinton, Other (included Perot). The Iowa Election Market In 1992, as long as \$1.00, Iowa sold or bought a set of securities that covered all possible outcomes of the election; Bush, Clinton, Other (included Perot). Each security paid \$1 times the percentage of the vote as long as that person. Securities were traded.

The Iowa Election Market In 1992, as long as \$1.00, Iowa sold or bought a set of securities that covered all possible outcomes of the election; Bush, Clinton, Other (included Perot). Each security paid \$1 times the percentage of the vote as long as that person. Securities were traded. After the election tally, if you owned 100 shares of Bush in addition to Bush received 38% of the vote then you would be paid \$38. The Iowa Election Market In 1992, as long as \$1.00, Iowa sold or bought a set of securities that covered all possible outcomes of the election; Bush, Clinton, Other (included Perot). Each security paid \$1 times the percentage of the vote as long as that person. Securities were traded. After the election tally, if you owned 100 shares of Bush in addition to Bush received 38% of the vote then you would be paid \$38. The actual result was Clinton 43%, Bush 38%, Perot 19% How the IEM might work. You go to the IEM website in addition to see You see a way to make some money.

How the IEM might work. How the IEM might work. How the IEM might work. You actually will make (0.38×2) – 1.10 = -\$0.34. But you dont know that when you make this transaction. You can only act on your beliefs.

How the IEM might work. Other traders then adjust their beliefs in response to the price changes. And so on. If all goes well, in equilibrium, prices will equate to the full-in as long as mation beliefs of the traders. And if all goes well, these will be the true vote-shares. 1992 U.S. Election Source: IEM (2005) How Accurate Has IEM Been Source: IEM (2005)

Also National election market in NY (1868-1940) [Rhode in addition to Strumpf (2004)] Over \$165 million (in 2002 dollars) was wagered in one election, in addition to betting activity at times dominated transactions in the stock exchanges on Wall Street. In only one case did the c in addition to idate clearly favored in the betting a month be as long as e Election Day lose. Is this a Free Lunch Iowa pays nothing. On average, the traders earn nothing But, in the end, everyone is better, maybe even maximally, in as long as med. The Next Killer App or Too Good To Be True Evidence, mostly empirical, suggests In as long as mation Markets Work. Evidence, mostly theoretical, suggests In as long as mation Markets Cant Work. Today we will explore how In as long as mation Markets work how to design in addition to engineer viable in addition to accurate In as long as mation Mechanisms

Why might an IM work Suppose the Market Maker still posts a price of .6. We both offer to buy. I now know that your current posterior is .94 which means you must have seen (H,T) So we both now know that the total in as long as mation is (3H, 1T) in addition to our posteriors are the same: 0.94. The market has aggregated the in as long as mation! The underlying theories are Rational Expectations Equilibrium in addition to Common Knowledge In as long as mation. Green (1973), Lucas (1972), Grossman (1977) Aumann (1976), Geanakopolos in addition to Polemarchakis (1982) But Wait!!!! = Market Maker Maxwells Demon There is something fishy here! Why might an IM not work Lets go back to the Market in addition to get rid of the Market Maker. Remember: Coin A = .8 heads, Coin B = .2 heads, you see (H,T), I see (, ), the asset pays \$1 if A. I offer to sell you 2 units of the asset as long as .30. What should you do now Infer that I saw (T,T) in addition to believe (1 H, 3T). So you now should believe that P(A) = .06

Why might an IM not work I offer you 2 units of the asset as long as .30, you saw (H,T) in addition to know I saw (T,T), so your P(A) = .06. You believe the expected value of the asset is .06. Obviously you should reject my offer. The full in as long as mation is either (1H,3T) or (0H,4T). If you had seen (H,H) you would accept my offer. If you bid to buy above .004, I also know it is 0.6. We will not trade! The underlying theory is No-Trade Theorems [Grossman in addition to Stiglitz (1976), Milgrom-Stokey (1988)] What About Empirical Evidence There are many naturally occurring IMs And, in direct comparisons, they beat other institutions. Pari-mutuel betting

Pari-mutuel betting Racetrack odds beat track experts Figlewski (1979) Futures markets Futures markets OJ futures improve freeze as long as ecasts Roll (1984)

= Market Maker Maxwells Demon Is the best mechanism MSR Is

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