LONG-TERM PREDICTION MARKETS

Abstract

Most prediction markets focus on events with a short time horizon such as forthcoming elections. Contracts are typically traded for periods measured in weeks, but rarely exceeding a year. There is great interest in using prediction markets for events with a long time horizon such as climate change outcomes. This paper develops an analytic framework for exploring the time horizon limitations of prediction markets and suggests a simple, practical solution: the market operator must invest cash holdings in a diversified financial portfolio that generates returns that reflect individual traders’ heterogeneous attitudes towards risk and return. The analytic framework identifies how the presence of an opportunity cost for investors reduces market liquidity through a participation constraint and biases the equilibrium price through an inherent money-at-risk asymmetry between long and short positions in a prediction market. This paper explores continuous outcome markets, which are relevant for science-related long-term predictions, along with familiar winner-takes-all markets.