Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

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In a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price is demonstrated to underreact to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first period price is followed by momentum.
Original languageEnglish
PublisherDepartment of Economics, University of Copenhagen
Publication statusPublished - 2009

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ID: 17083830