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A Market Approach to Forecasting: Background, Theory & Practice

Georgios G. Tziralis

presented in partial fulllment of the requirements for the degree of Doctor of Philosophy, in the Sector of Industrial Management and Operational Research, School of Mechanical Engineering, National Technical University of Athens Athens, 21 June 2013

0. Contents
I. Introduction II. Background III. Theoretical Properties IV. Theoretical Evaluation V. Empirical Analysis VI. Advanced Concepts VII. Conclusions

I. Introduction

1. Scope 2. Approaches 3. Motivation

I.I Scope
What men have seen they know; but what shall come hereafter, no man before the event can see. Sophocles Ajax, Chorus, lines 1417-1419, ca 450-440 BC

Forecasting, a task of aggregation, ltering and processing: a) ideally, collect all potentially related information, then b) lter only the relevant to the target variable parts & c) process the remaining data to arrive at conclusions.

I.2a Approaches

Three core approaches to forecasting: 1. Causal methods 2. Time-series methods 3. Judgmental methods

I.2b Causal methods

i) discover correlations between the target variable and other potentially related ones ii) assume such relationships do not change iii) apply such relationships to predict future prices + demonstrate a capacity to capture underlying relationships - difcult to discover, also not static

I.2c Time-series methods

i) discover underlying patterns across past data ii) assume such patterns remain valid iii) extrapolate them in the future + perform generally well in relatively static problems - incapable in dynamic environments (driving by the rear-view mirror issue)

I.2d Judgmental methods

i) expert opinions and intuitive judgments incorporated via surveys or similar tools ii) typically a single expert + the cheapest and most common technique in practice - hard for an expert to quantitively assess knowledge - difcult to identify experts, then elicit and weight opinions

I.3a Motivation

a universal forecasting algorithm remains an elusive


traditional approaches seem to have reached a ceiling any alternative mechanisms that organically perform
the core forecasting tasks in dynamic environments?

I.3b Motivation
human intelligence seems to excel at most parts of
the forecasting problem biases

yet, it remains hindered by endemic problems, such as how could one take advantage of the virtues of
collective human intelligence and at the same time cancel out its limitations?

relevant research eld remains underexplored, serves

as the context of this thesis

II. Background

1. Markets 2. Prediction markets 3. Literature review 4. Classication

II.0 Research Questions

Why & how do prediction markets work? What are their fundamentals of operation? What is their evolution in recent years? What is the existing volume of publications? Which are the topics covered by literature?

II.1a Markets
the best available mechanism for gathering and
aggregating dispersed information from agents

efcient markets hypothesis: markets reect the sum

of all available information about future events

theory of rational expectations: markets convey

information through the prices and volumes of assets

experimental economics: markets may be created

specically to collect, aggregate and publish information

II.1b Markets
Financial markets are institutions that incorporate by their very nature and facilitate, in one way or another, all four fundamental functions of investment, hedging, speculation and information aggregation. Primary function investment hedging speculation information aggregation Market institution stock market futures market wagering market ?

II.2a Prediction markets

Prediction markets are dened as markets designed and run for the primary purpose of mining and aggregating information scattered among traders; then transforming such information into market prices serving as predictions about specic future events.

II.2b Prediction markets

an efcient way of arriving into consensus about the
possibility of a future event

a well-working framework for belief aggregation an efcient mechanism of information incorporation

for future events

a mechanism with an accuracy that can be assessed largely an empirical (or social) science

II.3 Literature review

surveys and examines the totality of relevant

academic work at the time of writing

resulted in identifying 155 articles, increasing trend a comprehensive basis for understanding prediction
market research and its state of the art

no other review available, a contribution

II.4a Classication

II.4b Classication
a promising forecasting approach and largely
untouched research eld

no standard terminology as of yet ('prediction

markets' emerges as default) applications

a growing amount of research in various practical no standard market mechanism in place

III. Theoretical Properties

1. Market mechanisms 2. Prediction markets mechanisms 3. Properties for a coherent price function 4. A coherent price function I 5. A coherent price function II

III.0 Research Questions

What market mechanisms are used in general? What prediction market mechanisms are used? Which are the properties for a coherent (proper)
price function of a prediction market?

Are there any coherent price functions?

III.1a Market mechanisms

1. Continuous double auction (i.e. stock markets) 2. Market-maker (i.e. wagering with bookmaker) 3. Pari-mutuel (i.e. horse racing)

III.1b Continuous double auction

any case that pbid ! pask results into a transaction for any transaction to occur, there must be a

counterpart on the other side willing to accept the trade

in the case that the highest bid price is less than the
lowest ask, nothing happens

illiquidity issues, 'thin market' problem

III.1c Market maker

in most cases CDAwMM an agent who is nearly always ready to trade in the bookmaker case, the market institution sets the
odds only for other players to buy and not to sell money

exposure to risk of losing considerable amounts of

III.1d Pari-mutuel
people place wagers on which of two or more
wagered on it split the total amount invested

mutually exclusive and exhaustive outcomes will occur

when the true outcome becomes known, players who the cost of purchasing an equal share of the prots
remains constant, unconditional to when the wager was placed

no incentive for buying until either all information is

revealed, or the market is about to close

III.2a Prediction market mechanisms

No risk for the Innite Current information market institution liquidity capture CDA Market maker Pari-mutuel yes no yes no yes yes yes yes no

standard mechanisms not fully appropriate for prediction markets usage

III.2b Scoring rules

i=1,,n mutually exclusive and exhaustive outcomes
of future event

s scoring rule such as xi=si(ri), where x:monetary

reward, r:probability reported by an agent expectations to maximise her returns xi=ai+b*log(ri), where a,b constants

s is proper if ri=pi, namely the agent reports her true example of proper scoring rule (logarithmic):

III.2c Market scoring rules

Any proper scoring rule can be interpreted as an
automated market maker (Hanson 2003) outcomes equal)

The market maker sets initial expectations (e.g. all Each new trader agrees to compensate the previous
trader according to her previously submitted probability estimate

She also receives the scoring rule payment associated

with the probability estimate she submits

III.2d Market scoring rules

let j be the relevant security paying off for the event i also, qj the total quantity of security j held by all
traders combined

for the logarithmic scoring rule, the cost and price

functions become:

III.2e Dynamic pari-mutuel market

a hybrid between pari-mutuel & CDA (Pennock 2004) it always enables purchases of each outcome (yet one
can sell only what she owns)

buying shares of an outcome results into its stock

winning stock, proportionately to shares they hold

price increasing, while other stocks prices decrease

all money invested get redistributed to owners of the price function may vary according to properties

III.2f Adequacy
Market institution risk MSR DPM limited no Innite liquidity no yes Direction of liquidity buy/sell buy Current information capture yes yes

both mechanisms adequate, only minor issues MSR pays a xed monetary unit per share DPM pays per share an equal portion of the total

amount outstanding in the market at the time of closing

III.3a DPM price functions

Pennock (2004) suggests a couple: money and share

in simple case of n=2 outcomes (A,B), these are:

i) money ratio: pA/pB=MA/MB, where M total amount wagered ii) share ratio: pA/pB=kNA/NB, where N total number of shares, k constant

both present a number of unappealing properties,

further research required

III.3b Coherency properties

a set of properties providing for clarity, brevity,

intuitiveness and elegance is introduced price function

their satisfaction will provide for a coherent DPM no such framework existed, a contribution no already suggested functions satisfy it

III.3c Coherency properties

simple case, n=2 outcomes

reexiveness summation to 1 differentiability injection monotonicity (& invert) convergence to 1 convergence to 0

extension for n=k is straightforward

III.4a A coherent price function I

simple case, n=2 outcomes

satises all properties but invert monotonicity

III.4b A coherent price function I

extended case, n=k outcomes

satises all properties but invert monotonicity and

convergence to 1 for n>2

III.4c A coherent price function II

simple case, n=2 outcomes

conditional logic model, similar to logarithmic scoring

rule (b: sensitivity parameter)

all properties satised

III.4d A coherent price function II

extended case, n=k outcomes

all properties satised in a sense, a "unication" of DPM & MSR, via the
proposed price function

an elegant solution, core contribution of this thesis

IV. Theoretical Evaluation

1. Market Design 2. Convergence Properties 3. Discussion

IV.0 Research Questions

Does a proper prediction market work in theory? Will a proper prediction market converge to a
consensus equilibrium?

If yes, how fast is the convergence process? What is the best possible equilibrium? Will a proper prediction market always converge?

IV.1a Market design

model design balances between realistic detail and

meaningful simplicity

this one is biased towards simplicity

IV.1b Information structure

Boolean state space: s!{0,1}m with common prior
probability P(s)

Traders information space: X={0,1}n (n traders) initially, each trader is privy to one bit of information
xi (input bit)

conditional distribution of information, which is

common knowledge to all traders: Q(x|s): {0,1}mx{0,1}n "[0,1]

IV.1c Market mechanism

Market structure: pari-mutuel market, securities {k,l},
one for each binary outcome

Target: predict the value of f(s): {0,1}m x {0,1}n "[0,1], f

common knowledge to all traders quantity of shares bought

Price function: pk=exp(qk)/(exp(qk)+exp(ql)), where q Pay-off: all money redistributed to the winning
security (if f(s)=1 to security k, and vice versa)

IV.1d Market mechanism

The market is a multi-period Shapley-Shubik market


It proceeds in synchronous rounds; on each round,

each agent buys one share of a security, either k or l continues until equilibrium

After each round, new prices are announced; process

IV.1e Trader behavior

risk neutral, myopic, bidding truthfully rather than


traders probability distribution is updated after each

trading round via Bayes rule

the above are common knowledge

IV.2 Convergence properties

Price convergence:
without any new information, converges to consensus equilibrium in nite steps

Convergence speed: at most at n rounds, where n is

the number of traders

Best possible prediction: direct communication

equilibrium, where all market traders directly reveal their private information to each other

Convergence to the best possible prediction: not


IV.3 Discussion
the model described stands as an abstract departure
from reality, difcult to replicate in practice

it validated the essential value of markets as a decision

support tool for prediction and information aggregation purposes

the theoretical approach to the problem is by nature

rigid and increasingly complex

one needs to turn to experimental approaches for a

more extended study of the underlying issues

V. Empirical Analysis

1. The askmarkets platform 2. Experiment A 3. Experiment B 4. Experiment C 5. Deployment Framework

V.0 Research Questions

Does a proper prediction market work in practice? Is there a software platform supporting a proper
prediction market mechanism? equilibrium in practice? deployment?

Is a proper prediction market able to converge to What is a practical framework for prediction markets

V.Ia Context
moving from theory to practice, largely a social

no denite results, indications instead of proofs alternative approach to equilibrium in real world experimental results are assessed on this basis

settings: market converges (early enough & in a 'stable' way) to the correct outcome (market accuracy)

V.Ib The askmarkets platform

the proposed market framework had yet to be tested
in practice

a brand new software platform for prediction markets

was developed from scratch, together with partner Efthimios Bothos (NTUA EE PhD 2010) and administration of prediction marketplaces are presented hereafter

a state of the art tool for the creation, participation it was utilized in a series of cases, a number of which

V.Ic The askmarkets platform

V.2a Experiment A
academic context, testing information aggregation

Mech Eng NTUA graduate students, optional

participation (assignment bonus) hard to access

topic: Athens 2004 impact study, all data available but students also answered to a survey on the same
topic, before participating in the market

V.2b Experiment A

V.2c Experiment A
>100 students, >200 markets, >4k play-money
transactions in less than a month

markets beat the survey, with a 0,33 vs 0,23 avg error every single market converged to the correct

signicant improvement at a varying accuracy and

convergence speed a simple survey

better results came at the cost of running a market vs

V.3a Experiment B
business context, testing predictive capacities facilitated in a Greek, publicly traded, automotive

a couple of markets available, related to sales

estimates of core company products

employees across the supply chain and organisational

chart; no specic incentives, no active communication

V.3b Experiment B

V.3c Experiment B
6 month long, 265 employees registered, only 32 made
at least 1 transaction, 664 play-money transactions in total

sufcient acceptance and utilisation of the tool results were sufciently close to the desirable

management considered the mechanism materially

valuable and considerably improved, compared to other approaches

V.4a Experiment C
social context, testing predictive capacities hosted in a popular news portal, themed under
forthcoming Greek elections

open marketplace, traders could participate or create

market questions, no incentive other than a small gift to the winner

lasted less than two weeks, no surveys available during

this period to compare

V.4b Experiment C

V.4c Experiment C
45 random traders, 706 play-money transactions 14 markets, 7 with sufcient trading volume that were
further analysed

in all 7 cases, markets suggested the correct outcome;

most under slow convergence and low condence though lack of targeting, training and incentives

sufcient volume of participation and results, granted

V.5a Deployment Framework

a practicable framework for the deployment of
prediction markets

a few experiments cannot lead to universal principles that said, they sufce to provide a practical guide

good practices apply to cases satisfying typical

requirements of the experiments run

V.5b Design
the constituents of a prediction market are essentially
two: its stocks and traders, along with the mechanism that brings them together

generic rule of simplicity and intuitiveness, highly


if a trader has second thoughts before making a

majority of participants are familiar with

transaction, she will most probably not participate

exploit narratives and terminology that the vast

V.5c Stocks
focus on the right choice and clear denition of a
forecasting goal

short, clear and easily understood stock description small number of stocks (i.e. less than 4 or 5) is

predictions of absolute numbers rather than relative

numbers are preferred (e.g. high (>80%) rather than 80%)

V.5d Participants
the tasks essentially are to a) nd those who possess
or are capable to discover relevant information and b) incentivize and engage them to so do

in play-money cases, incentives alone are of limited


turn the targeted audience to an active community of

people who take pride in participating and having their say in the market

a market is successful when it becomes a daily topic

of conversation

V.5e Discussion
developed a state-of-the-art, prediction markets
platform from scratch participation

ran a diverse set of experiments, with sufcient all experiments suggested that the proposed
mechanism is capable to perform the tasks at hand

that said, empirical analysis largely stands as social

science, no generalised results can be extracted directions for further research

a rough deployment framework was provided, various

VI. Advanced Concepts: Event Detection

1. Background 2. Time Series Analysis 3.Volatility Modeling 4. Experimental Settings 5. Experimental Results

VI.0 Research Questions

What is the state-of-the-art in text mining for market

prediction and volatility analysis?

What is a model of volatility for prediction markets? How can such a model serve to detect events? Does such a model work in practice?

VI.1a Background
event detection: the task of monitoring news corpus requires as input a meta-mechanism that aggregates
information from news corpus by nature

to discover stories that discuss a previously unidentied event

there exists a proven -yet unidentied- relationship relatively virgin research eld; prediction markets
maybe a t

between the release of relevant news stories and the uctuation of prices

VI.1b Background
various attempts to correlate simple changes in

market prices with a signal of an event, or invert, with ambiguous results

volatility clustering: large changes tend to be followed

by large changes, of either sign, same for small changes

needs to be modelled appropriately, rendering

previous approaches of limited value

volatility analysis and GARCH modelling of prediction

markets time series introduced as input for text mining

VI.2 Time Series Analysis

CDA prediction market data from Intrade was used,
regarding US presidential elections techniques, picked SVMs

initially experimented with machine learning satisfactory error metrics at rst sight, however
predictions were reproducing past prices, approach abandoned

then, a GARCH(1,1) model was demonstrated and evidence for volatility clustering was also provided

veried as highly appropriate, adopted for further usage

VI.3 Volatility Modeling

a GARCH(1,1) model for the prediction of market
time series volatility on a daily basis

actual volatility prices are also retroactively known diff between predicted and actual volatility can nally
be computed

time instances of signicant divergence are isolated as

of high information value

the approach solves the volatility clustering issue, yet

at a high computational cost

VI.4 Experimental Settings

116 real-money prediction markets contracts with
signicant transaction volume for a 4yr period and actual volatility were highlighted

276 instances of high divergence between predicted number of occurrences of relevant for each contract important volatility signals versus important news
occurrences were eventually identied keywords were tracked via Google News Archive, for a period of 3 days before up to 3 days after each instance

VI.5 Experimental Results

news spikes before the volatility signal suggest the use
news the day before the error spike occurs relevant news occurring the days after of news as a leading indicator of volatility, and vice versa

average instance suggests a decreasing rate of relevant it was followed by a smaller but growing increase of no clear and signicant enough trend revealed however, the proposed approach essentially

contributed the ability to highlight such phenomena, with a signicantly improved condence rate

VII.1 Conclusions
I. Introduction Forecasting is far from a solved problem, and cannot be but so II. Background Markets emerge as an interesting approach to forecasting, extended literature review III. Theoretical Properties a coherent set of properties and a function satisfying them was contributed IV. Theoretical Evaluation theoretically and abstractedly, the proposed mechanism can work V. Empirical Analysis a set of real world experiments highlight the mechanism's adequacy

VII.2 Final remarks

This Thesis attempted an 180 degree turn from the
elegant, yet highly sophisticated approach

dominant trend of computationally expensive approaches

It regressed towards a simpler, transparent and more Prediction markets were studied in depth and width,
from literature to theory to experiments to practice literature, only future will tell

Ironically, should this Thesis innitesimally serve the

thank you
Georgios G. Tziralis