On the Observational Implications of Knightian Uncertainty

Abstract

We develop a model of a prediction market with ambiguity and derive testable implications of the presence of Knightian uncertainty. Our model can explain two commonly observed empirical regularities in betting markets: the tendency for longshots to win less often than odds would indicate and the tendency for favorites to win more often. Using historical data from Intrade, we further present empirical evidence that is consistent with the predicted presence of Knightian uncertainty. Our evidence also suggests that, even with information acquisition, the Knightian uncertainty of the world may be not "learnable" to the traders in prediction markets.