It Takes All Sorts: A Heterogeneous Agent Explanation of State-Contingent Claims Mispricing

Abstract

Finding what causes pricing anomalies is an important step towards improving market efficiency. The favourite-longshot bias is one of the longest-standing pricing anomalies in state-contingent claims markets. However, existing models are unable to capture its full complexity. We develop a game-theoretic model of heterogeneous agents in a fixed-odds market. Comprehensive analysis using market data and agent-based simulations demonstrate that our model explains real market behaviour, including that of the market maker, better than existing theories. This model can be used to better understand the relation between market ecology and mispricing in broader contexts such as option and prediction markets.