Skip to main content
← Back to P Definitions

Prediction market

What Is a Prediction Market?

A prediction market is an organized exchange where participants trade contracts whose payoffs are tied to the outcome of future events. These markets function as a mechanism for information aggregation, leveraging the "wisdom of crowds" to forecast uncertain events. The price of a contract in a prediction market typically reflects the collective probability that the event will occur, making them a unique tool within the broader field of market mechanisms. Unlike traditional financial markets focused on company performance or asset values, prediction markets specifically deal with propositions about future occurrences, ranging from political elections and economic indicators to product sales or scientific breakthroughs. Participants engage in speculation, buying and selling these event-based contracts based on their beliefs about the likelihood of an outcome.

History and Origin

The concept of using markets to forecast events predates modern financial exchanges, with documented instances tracing back to the Italian city-states in the early 16th century, where election markets on papal successors were reportedly common.10 The formalized, modern electronic prediction market emerged much later. A pivotal development was the establishment of the Iowa Electronic Markets (IEM) in 1988 by the University of Iowa's Tippie College of Business. Created for academic and research purposes, the IEM allowed traders to buy and sell contracts based on political election results and economic indicators, often demonstrating greater accuracy than traditional opinion polls.9 This initiative provided a scientific foundation for understanding how market prices could aggregate dispersed information to make robust forecasts.8

Key Takeaways

  • Prediction markets are exchanges where contracts are traded based on the outcome of future events.
  • The price of a contract in a prediction market generally reflects the perceived probability of the event occurring.
  • They aggregate dispersed information from diverse participants through financial incentives.
  • Prediction markets have shown effectiveness in various forecasting scenarios, sometimes outperforming traditional methods.
  • They are utilized for forecasting in areas like politics, economics, and corporate planning.

Interpreting the Prediction Market

Interpreting prices in a prediction market is relatively straightforward: the price of a contract often directly corresponds to the market's collective assessment of the probability of an event. For example, if a contract that pays $1 upon a specific candidate winning an election trades at $0.75, the market collectively believes there is a 75% chance that the candidate will win. This characteristic makes prediction markets a direct tool for price discovery regarding future uncertainties. Participants, motivated by the potential for profit, incorporate new information rapidly, leading to prices that reflect current market sentiment and available data. Changes in contract prices over time indicate shifts in collective belief about the likelihood of the event.

Hypothetical Example

Consider a hypothetical prediction market launched for the upcoming "Global Innovation Summit" to predict whether a specific technology, "QuantumAI," will be unveiled. A contract for "QuantumAI will be unveiled" is trading. Initially, the contract opens at $0.20, implying a 20% chance of unveiling.

  1. Early Trading: An influential tech blogger publishes an article suggesting QuantumAI is nearing completion. Participants, seeing this new information aggregation, buy the "unveiled" contract, driving its price up to $0.45.
  2. Expert Leak: A supposed internal memo is leaked, casting doubt on the technology's readiness. Traders, engaging in speculation, sell the contract, causing the price to fall to $0.30.
  3. Official Confirmation: Just before the summit, the keynote speaker's outline is released, explicitly mentioning QuantumAI. The contract price surges to $0.95 as certainty grows.

On the day of the summit, if QuantumAI is unveiled, contracts paying $1 for that outcome become worth $1, and holders profit. If it's not unveiled, they become worthless, resulting in a loss.

Practical Applications

Prediction markets find diverse practical applications across various sectors, demonstrating their utility as a powerful forecasting tool. In the corporate world, companies like Google and Ford have utilized internal prediction markets to forecast demand, product quality, project completion deadlines, and even external market events. These corporate markets, despite sometimes facing challenges like thinness or limited participation, have been shown to improve upon expert forecasts by significantly reducing prediction errors.7 Beyond internal corporate uses, prediction markets are widely employed for:

  • Political Forecasting: Predicting election outcomes, legislative actions, and policy decisions.
  • Economic Forecasting: Anticipating economic indicators like inflation rates, interest rate changes, or GDP growth.6
  • Project Management: Estimating project completion times or the success rate of new initiatives.
  • Sports and Entertainment: Forecasting game results, box office successes, or awards.

These applications leverage the market's ability to quickly assimilate and reflect new information, offering insights for decision making in dynamic environments.

Limitations and Criticisms

Despite their demonstrated accuracy in many instances, prediction markets are not without limitations and criticisms. A primary concern is their potential susceptibility to manipulation, particularly in markets with low liquidity or for events where a small amount of capital could disproportionately influence prices.5 While proponents argue that sufficient incentives encourage traders to correct any artificially induced price distortions through arbitrage, real-world examples, particularly in less regulated or smaller markets, have shown instances where manipulation attempts occur.4

Another criticism relates to regulatory oversight. Given their resemblance to gambling or derivatives trading, the legal and regulatory status of prediction markets can be ambiguous, leading to restrictions on participation or the types of events that can be traded. Ethical considerations also arise when markets are created for sensitive or harmful events, raising questions about incentivizing undesirable outcomes. Furthermore, while the "wisdom of crowds" is powerful, it can be hindered if the crowd lacks specialized knowledge for niche predictions, or if participants harbor collective biases, an area often explored in behavioral finance.

Prediction Market vs. Futures Contract

While both a prediction market and a futures contract involve trading contracts based on future events, their primary purposes and structures differ. A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, primarily used for commodities, currencies, or financial instruments. Its main functions are hedging against price fluctuations and enabling large-scale speculation on asset prices.

A prediction market, conversely, issues contracts whose value at expiry is explicitly tied to the binary (yes/no) or multi-option outcome of a specific event. The market price of a prediction market contract is typically interpreted as the probability of that event occurring. While one can use futures contracts for a form of prediction (e.g., oil futures prices predicting future oil supply/demand), their structure is designed for delivery or cash settlement based on the underlying asset's price. Prediction markets are fundamentally designed for forecasting and opinion aggregation, with contracts often settling to a fixed value (e.g., $1 or 100%) if the predicted event occurs, and $0 if it does not.

FAQs

Q: Are prediction markets legal?
A: The legality of prediction markets varies by jurisdiction and the specific design of the market. In some regions, they operate under specific exemptions for research or small-scale trading, while others may classify them as a form of gambling or unregulated option contracts. Regulatory bodies like the CFTC in the U.S. have historically limited their operation, though legal challenges and evolving interpretations are creating new pathways for event-based trading.

Q: How accurate are prediction markets?
A: Numerous studies suggest that prediction markets can be highly accurate, often outperforming traditional polling or expert forecasts, particularly for political events.2, 3 Their accuracy is attributed to the financial incentives that encourage participants to incorporate all available information, leading to efficient price discovery.

Q: Can prediction markets be used for personal investment?
A: While participants can make money by correctly predicting outcomes, treating involvement in prediction markets as a personal investment strategy carries significant risk management considerations. They are often subject to different tax treatments than traditional investments and can be highly speculative. Experts often suggest viewing participation more as an entertainment expense than a reliable investment vehicle.1