Fundamentals of Prediction Markets

Abstract

After a short history of prediction markets in Section 2.1, we define prediction markets as markets that run for “the primary purpose of aggregating information so that market prices forecast future events” (Berg and Rietz, 2003) in Section 2.2. The theoretic foundations of prediction markets are found in Hayek’s analysis of market-based economies and in the rose of information in Fama’s efficient market hypothesis in Section 2.3. The interaction between incentives for trade information revelation by trading transactions and the resulting adaption of prices is illustrated by a hands-on example in Section 2.4 on the operational principle of prediction markets.