Noise, Information, and the Favorite-Longshot Bias in Parimutuel Predictions

Betting and prediction markets provide a natural environment for testing theories of decision making under uncertainty and price formation. The uncertainty about the value of the assets traded in these markets is resolved unambiguously, and the outcome is observed publicly. In most cases it is also reasonable to presume that the realized outcomes are exogenous with respect to market prices. In contrast, in regular financial markets, the intrinsic value of assets is observed only in the long run (if ever) and is often affected by prices. In racetrack betting and lottery games throughout the world, a commonly adopted market structure is parimutuel wagering. According to the parimutuel system, the holders of winning tickets share the total amount of money bet on all outcomes in proportion to their bets, net of the takeout for taxes and expenses. The parimutuel odds that are paid out to winning bets (as a multiple of the amount wagered) depend