Can Manipulators Aid the Accuracy of Prediction Markets?

It is a few years now since I approached the editor of the prestigious academic journal, Economica, with an idea for publishing a special issue on the theme of gambling and prediction markets. The result was a conference I co-organized at the University of Riverside, Palm Desert, California, which played host to most of the leading academics in the field. The title of the conference was The Growth of Gambling and Prediction Markets: Economic and Financial Implications. I was given the additional task of co-editing the special issue. One of the papers arising out of that conference was penned by Professors Robin Hanson and Ryan Oprea, of George Mason University and the University of California, Santa Cruz respectively. Under the title, ‘A Manipulator Can Aid Prediction Market Accuracy’, a perspective on its basic message is offered by Alex Tabarrok at Marginal Revolution. Tabarrok was considering the impact of the clear attempt by at least one determined trader to manipulate one of the US election betting markets in favour of Senator John McCain. How much of a danger, Tabarrok asks, does this sort of activity pose for the whole concept of prediction markets? Not much, he argues, instead offering support for Hanson and Oprea’s finding that manipulation can actually improve prediction markets, for the simple reason that manipulation offers informed investors a free lunch. “In a stock market”, he writes, “… when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade. But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return. The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.” For this reason, it can be argued that while manipulation is possible, investors should soon move to take advantage of any price discrepancies thus created within and between markets, as well as to take advantage of any perceived mispricing relative to fundamentals. To this extent the expected value of the outcome of these transactions is a financial loss for the manipulator and a profit for the investors who act to exploit the mispricing. More importantly, the incentive the activity of the manipulator gives for others to become informed, and to trade on the basis of this information, is valuable in itself in improving the efficiency of the market. Tabarrok offers the additional observation that, considerations of predictive accuracy aside, there is one even more important lesson to be learned from the activities of the manipulators: “…that prediction markets have truly arrived when people think they are worth manipulating”. Yes indeed!

Links:

http://marginalrevolution.com/marginalrevolution/2008/10/manipulation-of.html

http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0335.2008.00734.x/full