What are Prediction Markets?

Prediction markets are specialized, small-scale financial markets operated to predict future events. While traditional markets exist to allocate resources, prediction markets are conducted solely for using the information “contained” in prices to make predictions about future events. The operators of prediction markets define artificial financial instruments or contracts based on some event of interest. The ultimate value of the contracts is contingent upon the outcome of that event. Using our research interests as an example, a typical question would be “Does the influenza vaccine being produced now include the dominant strain of influenza that will circulate next season?” In such a market, participants who are interested in the topic are invited to buy and sell contracts for “yes” and “no” throughout the influenza season until the answer is revealed in a pre-specified source (e.g., data from the World Health Organization). Traders participating in the market have information about the event of interest and are motivated to trade contracts by the prospect of making “profits” in the market. To make a profit, traders must buy contracts that are, according to their private information, undervalued by the market and sell those that are overvalued. The prices at which the contracts trade reflect a consensus belief about their future values and, thus, can be viewed as a prediction of the future event.

While the idea that prices convey information is much older, research using markets solely for the purpose of aggregating beliefs regarding a future event originated at the University of Iowa in 1988, when prediction markets were used to predict the outcome of the 1988 U.S. Presidential election. (See Forsythe R, Nelson FD, Neumann GR, Wright J. Anatomy of an Experimental Political Stock Market. American Economic Review 1992; 82:1142-1161.) The idea has evolved into a continuing project called the Iowa Electronic Market (IEM). The IEM has conducted well over 100 cash markets to predict the results of elections in the U. S. and other countries. The IEM has also conducted markets to predict interest rate decisions of the Federal Reserve, certain currency and stock prices, movie box office receipts, the capitalized value of initial public offerings of stock (e.g., Google), congressional approval of legislation, the future sale of Harry Potter Books, and other events. As part of its educational mission, the markets of the IEM have been used by more than 15,000 students in more than 100 colleges and universities throughout the world as a laboratory for hands-on experience with financial markets. Over the past 18 years, the prediction record achieved by the election markets of the IEM has been substantially superior to alternative mechanisms such as opinion polls. For example, for presidential elections, the average prediction error across 6 elections has been under 1.5%, while opinion polls for those same elections have had an average error of about 2.5%.

Although the IEM was the first prediction market, in the past decade several other prediction markets have been successful in both academic and commercial settings. For example, Eli Lilly and Company has used internal markets to help predict which developmental drugs have the best chance of advancing though clinical trials. Hewlett-Packard (HP) has used experimental markets to forecast sales of its printers, and these markets have outperformed statistical sales forecasts. Similarly, The Hollywood Stock Exchange has accurately predicted Oscar nominees and repeatedly forecasts opening-weekend box-office receipts more accurately than the movie industry. The Foresight Exchange operates markets to predict a variety of events, such as whether specific scientific conjectures will be proven.