Prediction Market
Also known as: Event contract, Event derivative
A contract paying $1 if an event happens and nothing otherwise, so its price reads as a probability. A forecasting instrument that is also, unavoidably, a wagering one.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
A prediction market sells contracts on whether something will happen. Each one pays $1 if the event happens and nothing if it does not. Because the payoff never changes, the price says something plain: a contract trading at 63 cents means the market thinks there is roughly a 63% chance.
It is the same instrument as a binary option. Two differences matter.
- Other traders set the price, by posting bids and offers. Nobody is quoting you a price while taking the opposite side of your bet.
- The thing being bet on is an event — an election, an inflation figure, a court ruling — rather than the price of something.
The interesting claim here is not that individual traders are good at forecasting. It is that a market pulls together what a lot of people each know a little of, and makes them put money behind it, which strips out the cheap talk. Whether that beats the alternatives is a question for evidence rather than argument, and the evidence is genuinely mixed.
- Asset class
- Alternatives (event-linked)
- Instrument type
- Binary event contract
- Traded
- Regulated exchanges in some jurisdictions; offshore elsewhere
- Typical users
- Forecasters, hedgers of event risk, speculators
3 · IntermediateHow it works in practice
Where the price stops being a clean probability
- The longshot bias. Contracts at very low prices trade persistently above their realised frequency. A 3% contract has historically resolved yes less often than 3% of the time — the same bias documented for decades in betting markets, and it survives in prediction markets too.
- The cost of capital. Buying a contract at 0.95 to make 0.05 ties up capital until resolution. Over six months that is an unattractive annualised return, so nobody arbitrages the last few cents — which is exactly why extreme prices are least reliable.
- Fees and spreads sit inside the price. A market quoted 0.62/0.65 has no single probability, and the mid is a convenience.
- Thin markets are opinion, not aggregation. A contract with little volume reflects whoever showed up, and the informational claim rests entirely on depth.
Genuine hedging uses
| Exposure | Event contract as a hedge |
|---|---|
| A regulated firm facing a rule change | Buy the contract on the rule passing |
| A farmer facing weather | Overlaps with weather derivatives, at retail size |
| A business exposed to a policy outcome | Cheaper than restructuring operations in advance |
These are real, and they are also the argument regulators have found least persuasive — because the same contract serves a hedger and a gambler identically, and the venue cannot tell them apart.
4 · AdvancedPricing & valuation
The evidence on accuracy, honestly summarised
- Prediction markets have generally matched or modestly beaten polling averages for election outcomes, and have done well on binary, well-defined, near-dated questions with liquid markets.
- They have done poorly on long-dated questions, on questions with ambiguous resolution criteria, and at extreme probabilities.
- They are not magic aggregators: they reflect the beliefs of the people trading them, weighted by capital. A market dominated by one demographic prices that demographic's beliefs, and the money-weighting is a feature only if the informed are also the well-capitalised.
- The most robust finding is comparative rather than absolute: a market price is a hard-to-beat baseline, and beating it consistently requires genuine private information — the same standard as any other market.
The regulatory position is the product's main risk
Jurisdictions differ sharply, and the differences are not stable:
- Some regulators have authorised event contracts on designated exchanges with position limits and defined categories.
- Others treat them as gambling, subject to entirely separate licensing, or prohibit them outright.
- Contracts on elections have been the most contested category, litigated in several jurisdictions with outcomes that have shifted more than once.
- Offshore and crypto-settled venues operate outside all of this, and carry counterparty and settlement risks that no regulated exchange would permit — the custody question, again.
Resolution risk is the underrated one
Every contract depends on an agreed source declaring the outcome. Ambiguous wording, a delayed source, a revised statistic or a disputed result creates genuine settlement risk on a contract whose whole appeal is that the payoff is unambiguous. Serious venues publish detailed resolution criteria for exactly this reason, and reading them is the diligence — the payoff structure has no subtlety, and the definition has all of it.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.