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The Betfair Prof: Like them or loath them, you simply can't ignore prediction markets

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Professor Leighton Vaughan Williams runs us through the background of prediction markets, why they are so important and even how Daniel Day-Lewis could have hedged his bets at the Oscars last night

Prediction markets are rapidly emerging. They are essentially markets for contracts whose values depend on the outcome of future uncertain events. As such, prediction markets can provide estimates of the probability of events occurring, and have on this account been used to predict uncertain outcomes ranging from the box office success of movies, through vote shares and election outcomes, to the sales of Hewlett-Packard printers, the success of new drugs at Eli Lilly and the probability of meeting project deadlines at Google.

The theoretical underpinning for the value of prediction markets derives from what is known as 'the efficient markets hypothesis.' This is the hypothesis that markets efficiently assimilate all available information, and stems from the view that relevant information concerning the likelihood of future events is dispersed among the opinions and intuitions of many people (the 'wisdom of crowds').

The mechanisms underlying prediction markets vary but they all offer a means of aggregating this information. Thus, some prediction markets (like Tradefair) work on an explicit binary system. Outcomes are classified on a 0 to 100 scale (100/0 = will/will not occur) and clients are able to bet whether the outcome will end up 100 or 0, i.e. it is all-or-nothing, either the event occurs or it doesn't. Prediction markets such as Betfair operate instead by allowing all the clients of the exchange to accept, request or offer odds about the likelihood of an event, to a stated volume. Basically, this is similar to a binary model in that the outcome either occurs or it does not but the mechanism for making and settling contracts is different.

There is a body of evidence that all such prediction markets have proved to be accurate gauges of political, economic and cultural change and their forecasts have outperformed alternative forecasting methodologies. The success and potential of these markets in predicting public events and corporate outcomes has in consequence generated substantial interest among social scientists, policymakers, and the business community.

In summary, a good deal of the research completed to date suggests that prediction markets can offer the promise of efficient forecasts either alone or as a supplement to other mechanisms like opinion surveys, group deliberations, panels of experts and focus groups. In addition, prediction markets have the potential to serve as a mechanism to help market participants hedge their exposure to social, cultural, political, and economic events, ranging from the risk to particular vested interests of particular political parties being elected to office to more general economic risks such as those associated with interest rate and currency exchange movements.

If you were Daniel Day-Lewis you could even have offered odds that you would not win the 'Best Actor' Oscar, so as to hedge your bets. As it turns out, you would have lost the bet but won the Oscar!

Like them or loath them, therefore, you simply can't ignore them and now there is a dedicated peer-reviewed academic journal, the 'Journal of Prediction Markets' (www.predictionmarketjournal.com) which publishes some of the latest and best available research. "Knowledge is power", declared Sir Francis Bacon in 1597, and knowledge of the future has always been a critical aspect of this. Prediction markets offer the portal. We are now invited to step through.

Professor Leighton Vaughan Williams is the Director of the Political Forecasting Unit and Betting Research Unit of Nottingham Business School, Nottingham Trent University

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