Price dynamics in political prediction markets

Abstract

Prediction markets, in which contract prices are used to forecast future events, are increasingly applied to various domains ranging from political contests to scientific breakthroughs. However, the dynamics of such markets are not well understood. Here, we study the return dynamics of the oldest, most data-rich prediction markets, the Iowa Electronic Presidential Election "winner-takesall" markets. As with other financial markets, we find uncorrelated returns, power-law decaying volatility correlations, and, usually, power-law decaying distributions of returns. However, unlike other financial markets, we find conditional diverging volatilities as the contract settlement date approaches. We propose a dynamic binary option model that captures all features of the empirical data and can potentially provide a tool with which one may extract true information events from a price time series.econophysics | information aggregation | wisdom of the crowd | binary model P rediction markets trade specifically designed futures contracts with payoffs tied to upcoming events of interest (1). A common type of prediction market contract is a binary option contract that pays off $1 if an event occurs and $0 otherwise. The contract design, which differentiates them from typical futures contracts, allows prices to be used as direct forecasts of event probabilities (2-5).Although betting on election outcomes was quite common in the United States prior to the Second World War as discussed in ref. 6, emergence of modern prediction markets, with the goal of information aggregation and revelation, can largely be traced back to the markets introduced by the Iowa Electronic Markets (IEMs) in 1988 (7). Since then, prediction markets have been created for election outcomes (7), financial results of companies (8), scientific breakthroughs (9), incidence of infectious disease (10), geopolitical events (9), box office takes of movies (11), the outcomes of sporting events (12), and hurricane landfalls (13, 14), among others. They have also been proposed for topics ranging from terrorist attacks (15) to future Olympic sites (16). Hedge Street (17) now trades binary option contracts on gold, silver, crude oil, and foreign exchange. More significantly, the Chicago Board of Trade (CBOT) recently created binary options markets on the Federal Funds target rate (18), a leading indicator of the U.S. economy.Given their accuracy, reaction speed, and data richness (3, 19-23), prediction markets provide researchers with the opportunity to precisely assess how external factors shape collective beliefs about the likelihood of a given event. Here, we consider the paradigmatic case of U.S. presidential elections. We use the tools of financial time series analysis and econophysics (24-26) to investigate the price dynamics of prediction markets with the goal of developing methods to identify the truly critical events during presidential campaigns. There are numerous known empirical regularities for price dynamics in stock, foreign exchange, commodity spot and f...

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