I thought about this a bit more, and I’m worried that this is going to be a long-running problem for the reliability of prediction markets for low-probability events.
Most of the problems we currently observe seem like “teething issues” that can be solved with higher liquidity, lower transaction costs, and better design (for example, by having bets denominated in S&P 500 or other stock portfolios rather than $s). But if you should understand “yes” predictions for many of those markets as an implicit bet on differing variances of time value of money in the future, it might be hard to construct a good design that gets around these issues to allow the markets to reflect true probabilities, especially for low-probability events.
(I’m optimistic that it’s possible, unlike some other issues, but this one seems thornier than most).
for example, by having bets denominated in S&P 500 or other stock portfolios rather than $s
Bets should be denominated in the risk-free rate. Prediction markets should invest traders’ money into T-bills and pay back the winnings plus interest.
I believe that should be a good enough incentive to make prediction markets a good investment if you can find positive-EV bets that aren’t perfectly correlated with equities (or other risky assets).
(For Polymarket the situation is a bit more complicated because it uses crypto.)
I think in an ideal world we’d have prediction markets structured around several different levels of investment risk, so that people with different levels of investment risk tolerance can make bets (and we might also observe fascinating differences if the odds diverge, eg if AGI probabilities are massively different between S&P 500 bets and T-bills bets, for example).
I believe the correct way to do this, at least in theory, is to simply have bets denominated in the risk-free rate—and if anyone wants more risk, they can use leverage to simultaneously invest in equities and prediction markets.
Right now I don’t know if it’s possible to use margin loans to invest in prediction markets.
Wouldn’t higher liquidity and lower transaction costs sort this out? Say you have some money tied up in “No, Jesus will not return this year”, but you really want to bet on some other thing. If transaction costs were completely zero then, even if you have your entire net worth tied up in “No Jesus” bets you could still go to a bank, point out you have this more-or-less guaranteed payout on the Jesus market, and you want to borrow against it or sell it to the bank. Then you have money now to spend. This would not in any serious way shift the prices of the “Jesus will return” market because that market is of essentially zero size compared to the size of the banks that will be loaning against or buying the “No” bets.
With low enough transaction costs the time value of money is the same across the whole economy, so buying “yes” shares in Jesus would be competing against a load of other equivalent trades in every other part of the economy. I think selling shares for cash would be one of these, you are expecting loads of people to suddenly want to sell assets for cash in the future, so selling your assets for cash now so you can buy more assets later makes sense.
Update: edited numbers, earlier one was incorrect.
IMO in real world examples (not meme examples like this religious one) tail risk will often dominate the price calculation, not time value. Time value seems relevant here only because the tail risk is zero. (Both buyer and seller agree that probability of yes on this market is zero)
Let’s say actual probability of some event is 3% yes and both parties agree on this. It still could be rational for a larger investor to buy no and a small investor to buy yes at 3.5% for example. Insurance market is analogous to this, it is possible for both the insurance buyer and seller to be rational at the same time because there is transfer of tail risk. The only person who can rationally accept a 3.5% chance of a $1B portfolio going to zero is someone who owns over $10B. (Assuming a utility function that makes sense for a human being) So it’s the largest investors and ultimately federal banks who absorb most of the tail risk of society.
Also ofcourse not everyone is rational when it comes to avoiding taking on tail risk, 2008 financial crisis is an example of this. Beyond a point if federal banks can’t absorb the tail risk they diffuse the losses to everyone.
I’m guessing the actual reason you’re interested in this is because you want prediction markets on existential questions, and there too the actual question is who absorbs the tail risk of society on behalf of everyone else.
P.S. In markets that are not low probability, variance of asset price (not just time value) will matter when constructing optimal portfolio. So sharpe ratio is a better metric to study than expected value. In general I guess people without financial background are not used to thinking about variance risk and tail risk.
I thought about this a bit more, and I’m worried that this is going to be a long-running problem for the reliability of prediction markets for low-probability events.
Most of the problems we currently observe seem like “teething issues” that can be solved with higher liquidity, lower transaction costs, and better design (for example, by having bets denominated in S&P 500 or other stock portfolios rather than $s). But if you should understand “yes” predictions for many of those markets as an implicit bet on differing variances of time value of money in the future, it might be hard to construct a good design that gets around these issues to allow the markets to reflect true probabilities, especially for low-probability events.
(I’m optimistic that it’s possible, unlike some other issues, but this one seems thornier than most).
Bets should be denominated in the risk-free rate. Prediction markets should invest traders’ money into T-bills and pay back the winnings plus interest.
I believe that should be a good enough incentive to make prediction markets a good investment if you can find positive-EV bets that aren’t perfectly correlated with equities (or other risky assets).
(For Polymarket the situation is a bit more complicated because it uses crypto.)
I think in an ideal world we’d have prediction markets structured around several different levels of investment risk, so that people with different levels of investment risk tolerance can make bets (and we might also observe fascinating differences if the odds diverge, eg if AGI probabilities are massively different between S&P 500 bets and T-bills bets, for example).
I believe the correct way to do this, at least in theory, is to simply have bets denominated in the risk-free rate—and if anyone wants more risk, they can use leverage to simultaneously invest in equities and prediction markets.
Right now I don’t know if it’s possible to use margin loans to invest in prediction markets.
Wouldn’t higher liquidity and lower transaction costs sort this out? Say you have some money tied up in “No, Jesus will not return this year”, but you really want to bet on some other thing. If transaction costs were completely zero then, even if you have your entire net worth tied up in “No Jesus” bets you could still go to a bank, point out you have this more-or-less guaranteed payout on the Jesus market, and you want to borrow against it or sell it to the bank. Then you have money now to spend. This would not in any serious way shift the prices of the “Jesus will return” market because that market is of essentially zero size compared to the size of the banks that will be loaning against or buying the “No” bets.
With low enough transaction costs the time value of money is the same across the whole economy, so buying “yes” shares in Jesus would be competing against a load of other equivalent trades in every other part of the economy. I think selling shares for cash would be one of these, you are expecting loads of people to suddenly want to sell assets for cash in the future, so selling your assets for cash now so you can buy more assets later makes sense.
The comment above may open a Flood of Jesus-Backed Securities and Jesus-Leveraged Loans. Heavens!
Update: edited numbers, earlier one was incorrect.
IMO in real world examples (not meme examples like this religious one) tail risk will often dominate the price calculation, not time value. Time value seems relevant here only because the tail risk is zero. (Both buyer and seller agree that probability of yes on this market is zero)
Let’s say actual probability of some event is 3% yes and both parties agree on this. It still could be rational for a larger investor to buy no and a small investor to buy yes at 3.5% for example. Insurance market is analogous to this, it is possible for both the insurance buyer and seller to be rational at the same time because there is transfer of tail risk. The only person who can rationally accept a 3.5% chance of a $1B portfolio going to zero is someone who owns over $10B. (Assuming a utility function that makes sense for a human being) So it’s the largest investors and ultimately federal banks who absorb most of the tail risk of society.
Also ofcourse not everyone is rational when it comes to avoiding taking on tail risk, 2008 financial crisis is an example of this. Beyond a point if federal banks can’t absorb the tail risk they diffuse the losses to everyone.
I’m guessing the actual reason you’re interested in this is because you want prediction markets on existential questions, and there too the actual question is who absorbs the tail risk of society on behalf of everyone else.
P.S. In markets that are not low probability, variance of asset price (not just time value) will matter when constructing optimal portfolio. So sharpe ratio is a better metric to study than expected value. In general I guess people without financial background are not used to thinking about variance risk and tail risk.
Polymarket could consider at least being explicit about that limitation and disallow wagers beyond 99% like Kalshi and Manifold currently do:
Keep in mind their goal is to take money from gambling addicts, not predict the future.
Spot on!