Strategic foundations of prediction markets and the efficient markets hypothesis

This paper studies information aggregation in pure common value double auc-tions with a continuum of traders. This trade environment captures some of the main features of prediction markets. The population includes both strategic traders and non-strategic (näıve) agents whose bidding behavior is not influenced by opponents ’ equilibrium strategies. Existence and uniqueness of monotone equi-librium prices is shown under mild conditions on the distribution of näıve bids. In any such equilibrium, the mapping from asset values to prices has a domain split into two distinct areas: a revealing region, where prices equal values, and a non-revealing region. There is a strictly positive lower bound on the share of näıve traders below which prices are always fully revealing and an upper bound beyond which prices are almost nowhere revealing. This indicates that, contrary to prevailing views, non-negligible levels of noise or liquidity trade are compatible with perfect information aggregation, although even moderate levels of noise can lead to nowhere revealing prices. An empirical method to distinguish between the revealing and non-revealing regions is suggested. JEL Classification: C72, D44, D82