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Rajiv Sethi on the interpretation of prediction market data

- March 11, 2011

Before you use prediction market prices as measures of probability, read this from economist Rajiv Sethi:

As the election season draws closer, considerable attention will be paid to prices in prediction markets such as Intrade. Contracts for potential presidential nominees are already being scrutinized for early signs of candidate strength. . . .

This interpretation of prices as probabilities is common and will be repeated frequently over the coming months. But what could the “perceived likelihood according to the market” possibly mean?

Prediction market prices contain valuable information about this distribution of beliefs, but there is no basis for the common presumption that the price at last trade represents the beliefs of a hypothetical average trader in any meaningful sense.

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