Modeling a presidential prediction market

Prediction markets now cover many important political events. The 2004 presi-dential election featured an active prediction market at Intrade.com where securities addressing many different election-related outcomes were traded. Using the 2004 data from this market, we examined three alternative models for these security prices with special focus on the electoral college rules that govern US presidential elections to see which models are more (or less) consistent with the data. The data reveal dependen-cies in the evolution of the security prices across states over time. We show that a simple diffusion model provides a good description of the overall probability distribu-tion of electoral college votes, while an even simpler ranking model provides excellent predictions of the probability of winning the presidency. Ignoring dependencies in the evolution of security prices across states leads to considerable underestimation of the variance of the number of electoral college votes received by a candidate, which in turn leads to overconfidence in predicting whether or not that candidate wins the election. Overall, the security prices in the Intrade presidential election prediction market appear jointly consistent with probability models that satisfy the rules of the electoral college. ∗We wish to acknowledge Dominic Soon for invaluable research assistance, Ray Fair for his helpful com-ments on earlier versions of this work, and the associate editor and two anonymous reviewers for suggestions that greatly improved the paper