On prices and returns in commercial prediction markets

Abstract

The Commodity Futures Trading Commission (CFTC) has recently licensed a commercial prediction market to operate in the US. With regulatory restrictions lifted, these markets can now play the important role that has been often envisaged for them. For example, investors can use them to hedge various event-related risks directly rather than indirectly via portfolios expected to move a certain way if events occur. Commercial prediction markets charge fees, an element that has not been incorporated into previous theoretical work on these markets. We examine the impact of fees on prediction market prices and returns by introducing them to a model in which the market price equals the true probability when there are no fees. We find that existing fee models mean contract prices for low probability outcomes are below the true probability but the impact of fees means prediction markets feature a form of favorite-longshot bias: Post-fee loss rates depend negatively on the probability of the event being backed. We show this result holds even if prediction market operators set a fee structure that is more generous to contracts with a low probability of success.