Some Evidence of the Efficiency of a Speculative Market

Author(s): Mukhtar M. Ali
Source: Econometrica, Vol. 47, No. 2 (Mar., 1979), pp. 387-392
Published by: The Econometric Society
Stable URL: http://www.jstor.org/stable/1914189
Accessed: 06-07-2016 11:21 UTC

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Econometrica

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Econometrica, Vol. 47, No. 2 (March, 1979)

SOME EVIDENCE OF THE EFFICIENCY OF A SPECULATIVE
MARKET

BY MUKHTAR M. ALI1

It is well known that the returns on various betting opportunities at a racetrack are
determined by a competitive bidding of the bettors in a natural environment of their
decision making. In this paper, two simple bets of unknown but identical winning
probabilities are identified. An analysis of 1,089 observations shows the data are consistent
with the hypothesis that both bets are identically priced, an implication of an efficient
speculative market.

1. INTRODUCTION

IN MANY RESPECTS, valuation of a bet in racetrack betting is similar to the
valuation of a stock in the stock market. In both cases, future earnings are
unknown and investors (bettors) bid against each other to determine the prices or
returns on their investments. Baumol [2, p. 46] maintains that the market of
racetrack betting closely approximates the efficient market hypothesis on the
ground that

... all opportunities for profit by systematic betting are eliminated. Bets at ten to one will in
the long run come off almost as badly as bets at three to one.

However, Ali [1] has shown from an analysis of over 20,000 races that on the
average, one would lose 10 cents per dollar bet by betting to win on the first
favorite, the horse with the lowest odds in a race, whereas he would lose 19 cents
per dollar bet by betting to win on the second favorite, the horse with the second
lowest odds.
Rosett [6] claims that the relationship between the return from a bet if it
succeeds, and its winning probability is consistent with the hypothesis that bettors
are rational, sophisticated, and have a strong preference for low-probability-high-
return bets and thus it is consistent with the efficient market hypothesis.2 But his
estimated relationship, as derived from this hypothesis, explains only part of his
data and consistently over-estimates the returns of low probability bets. Although
this casts doubts on the validity of his claim, it does not necessarily contradict the
efficient market hypothesis.
In this paper, two distinctly different bets with identical winning probabilities3
are identified. It is shown that the hypothesis that both bets are identically priced,

1 The author wishes to acknowledge the help received from his wife Julia W. Ali in collecting the
data for the present analysis. Comments from W. E. Wecker and S. I. Greenbaum are appreciated. I
am highly grateful to T. Hatta for comments clarifying some fundamental issues.
2 Bettors are rational in the sense that no one prefers a bet with a smaller winning probability and
the same or lower return or with a lower return and the same or lower winning probability to what is
available to him. Bettors are sophisticated in the sense that the winning probabilities of the bets are
known to them.
3 These are objective probabilities. Objective probability of an event is defined as the long run
relative frequency when the experiment is repeated (the race is run) infinitely many times under the
same conditions.

387

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388 M. M. ALI

an implication of an efficient market, cannot be rejected. Section 2 outlines the
construction of two such bets and describes the methods of analysis. Empirical
findings and conclusions are in Section 3.

2. METHODOLOGY

There are various betting opportunities at a racetrack. The odds on a bet are
profits per dollar bet to a successful bettor and are determined from the bets made
by the public, and the track-take and breakage. A fixed proportion of the amount
bet in a race is taken out by the track for maintenance costs, taxes, and profits,
before it distributes the rest to the successful bettors. This proportion is known as
the track-take. The breakage arises because of the following two restrictions: (a)
odds cannot be below a certain prescribed minimum, and (b) odds are rounded
downward except when (a) is in effect, in which case it is rounded upward. For the
races analyzed, the odds are rounded to either ten or five cents and the minimum
odds are also either ten or five cents depending on the particular racetrack.
Odds for different types of bets-win, place, show, daily double, quinella,
etc.-are determined separately. Let us take the case of a win bet. Suppose there
are H horses numbered 1, 2, . . ., h, .. . , H, and let Xh be the total amount of bet
for horse h to win. Then W = Mh1 Xh is the total win bet in the race also known as
the win "pool". Let the track-take and breakage be a; then the total money to be
distributed to the successful win bettors is (1 - a) W and the odds on horse h are

ah=[(1-a)W-- Xh]/Xh (h =1,2, . . H).

In other words, return per dollar bet to a successful bettor is (1 + ah) and the return
is zero to an unsuccessful bettor. Thus, the returns per dollar bet are market
determined through a competitive bidding of the bettors.
In the daily double bet one chooses a horse in the first race and another in the
second race during a racing day(night) and before the first race is run. The bet is
successful only when the chosen horses win their respective races. A parlay can be
constructed by choosing the same two horses before the first race is run where a bet
is made on the horse in the first race to win and if it wins, the total return from this
successful bet is bet on the horse in the second race to win. It can be verified that
winning probabilities of such a daily double and parlay are the same.
Let D be the return per dollar bet on a daily double and P be the return on a
parlay. D can be observed directly, but P must be derived. If the odds on the win
bets for the chosen horses in the first and second races are a and b, respectively,
then P can be shown to be (1 + a)(1 + b). Note that a, b, and D are determined
from distinctly different betting pools and hence D and P are separately market
determined.
The cost of a bet can be defined to be the amount that must be paid for a dollar
return from a successful bet. This will be the reciprocal of the return. As a fraction
of every wager made represents track-take and breakage, which can be inter-
preted as transaction cost, the cost of a bet has two components: transaction cost
and price of the bet. Thus, the price and cost of a bet would be identical if there is

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EFFICIENCY OF A MARKET 389

no transaction cost. If the return from a bet is R when the track-take and breakage
(transaction cost) is a, then the return would have been R/(1 - a) in the absence of
such a transaction cost; and as the cost of a bet is the reciprocal of its return, the
cost of the bet in the absence of the transaction cost would have been (1- a)/R
which would then also be the price of the bet. It then follows that the price of a
daily double is (1 - a)/D, where D is the daily double return. If the return on a
parlay is P, then P = (1 + a)(1 + b), where 1 + a is the return from the bet for the
chosen horse in the first race to win and (1 + b) is the return from the bet for the
chosen horse in the second race to win. Without the track-take and breakage of a,
the returns on these win bets would have been (1 + a)/(l - a) and (1 + b)/(l - a),
respectively, and therefore, the parlay return would have been P/(1 - a )2. Hence,
the price of the parlay is (1 - a)2/p. It can be verified that the fraction of the total
cost representing the transaction cost is higher for a parlay bet than for a daily
double bet.
It can be seen that the daily doubles and the parlays are priced separately. Any
daily double is priced in relation to all possible daily doubles involving the first two
races. The parlay prices result from the prices of the win bets in the first two races.
Any win bet is priced in relation to all possible win bets in that race and in that race
alone.
If the market is efficient, the bets will be valued according to their intrinsic
worth, i.e., their probability distributions alone, and thus, the price of a parlay bet
will equal the price of the corresponding daily double bet. However, if the
speculative motive of the bettors plays a significant role in pricing the bets, then
this equality cannot be guaranteed; rather it is likely to be violated. If the price of a
parlay differs from that of the corresponding daily double, there does not seem to
exist any motivation from the mere rationality of the bettors that can equalife
these prices. If the cost (price plus transaction cost) of a parlay is below the cost of
the corresponding daily double, the potential bettors of the daily double will find it
profitable to bet the parlay and such a betting may equalize the costs. However, as
the transaction cost of the parlay bet is higher than that of the daily double bet, the
price of the parlay can still be below the price of the daily double, i.e., the price
inequality can exist. Utilizing the definition of odds on a bet, it can be verified that
the sum of the costs of all the parlay bets involving the first two races is 1/(1 - a )2,
whereas the corresponding sum for the daily double bets is 1/(1 - a). As 1/(1 -
a)2 is larger than 1/(1 - a), it follows that inevitably the cost of at least some
parlay will be larger than the cost of the corresponding daily double. However,
mere higher cost of a parlay over the corresponding daily double cost does not
guarantee the equality in their prices. The preceding discussions show that the
price equality implication of the efficient market hypothesis is not an empty
proposition.
The observed daily double return, D, can be different from its true value. The
true daily double return, DT, is defined to be the one which is obtained if there is no
friction in the market. The true parlay return, PT, is similarly defined. In practice,
the market may not be free from frictions. For example, there is no secondary
market where bettors can exchange bets already made. Further, no bet can be less

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390 M. M. ALI

than $2 and some bets cannot be less than $3. Moreover, the equilibrating process
which adjusts D towards DT works for only a finite length of time. There may be
numerous other factors influencing the workings of the market. However, none of
these seemed to have a systematic effect on the determination of D. The aggregate
influence of all these factors will be called unsystematic effects on D and we will
view

D =DT+eD

where eD is the error in the observation due to the unsystematic effects. The error
eD can be positive or negative and can be assumed to have zero mean in repeated
sampling. DT is expected to depend upon the winning probability of the bet. As
this probability differs from observation to observation, DT will be different at
different observations. However, as the unsystematic effects on D can be assumed
to be independent and remain invariant in basic structure from observation to
observation, eD's can be taken as a random sample from a population with zero
mean and unknown variance.
We view the observed parlay return, P, in a similar fashion so that

P=PT+ ep

where ep is the error in observation and the ep's are a random sample from a
population with zero mean and unknown variance.
Following our earlier discussions, the price of a daily double with a return, DT is
(1- a)/DT and the price of the corresponding parlay with a return, PT is
(1-a )2/PT. Thus, a test of the efficient market hypothesis can be achieved by
testing the implication, (1 - a)/DT = (1- -a)2/PT, or (1 - a)DT = PT.
In order to test (1- a)DT = PT, we note the random variable, (1- a)D -P has a
mean, ILD_P = (1- a)DT-PT and an unknown variance, 2_p. Thus, the postu-
lated hypothesis can be tested by testing to see whether A1D-P = Oor not.
From a sample of size N, an unbiased estimate of I.D-P and that of _2-p can be
obtained, respectively, as

A 1 -
-LD-P Exi = X
N

and

OD-P N-I (xi X)
where Xi = (1- a)Di -Pi is the ith observation. Thus, an unbiased estimate of the
variance of /.D-P is O/D_p1N and the standard error of the estimate, 12D-P, can be
computed as

S.E.(/ID-P) = D -P/IVN.
For large N, it is well known that the sampling distribution of
A

Z 1D-P - AD-P
S.E.(iAD-P)

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EFFICIENCY OF A MARKET 391

is well approximated by a normal distribution with mean zero and unit variance.
Thus, the hypothesis, LD-P = O, can be tested using the statistic Z, and referring it
to the standardized normal distribution.

3. EMPIRICAL FINDINGS AND CONCLUSIONS

The data were collected from the race results published in The Horseman and
Fair World during September through December, 1975. The data consist of 1,089
observations from 34 racetracks in the U.S.A. and Canada. Each observation
consists of the winning daily double return, D, and the return on a $2 bet on each
of the horses finishing first in the first and second races of a racing day (night).
From these returns, the respective odds on a win bet are constructed and
therefrom the parlay return, P is computed. The track-take and breakage, a is
taken to be 0.18 which is an average a found in Ali [1] from an analysis of over
20,000 similar races.4'5 We find

JID-P- -0.5931

and

S.E.(ZD-P) = 0.5673,

so that the computed Z when the market is efficient is - 1.0455. Thus, ILD-P does
not differ significantly from zero and hence the efficient market hypothesis cannot
be rejected.
In conclusion, two bets of equal winning probabilities have been shown to be
equally priced which is an implication of an efficient market. One of the two bets is
a daily double and the other is the corresponding parlay. The data are obtained
from a controlled experiment conducted under a natural environment of the
decision makers. This can be contrasted with various laboratory studies (Preston
and Baratta [5], Mosteller and Nogee [4], Rosett [7]) to learn human decision
behavior under uncertainty. The conclusion derived is independent of any
behavioral assumption such as risk preference, risk aversion or risk neutrality of
the individuals except that they are rational. The validity of the conclusion
requires no assumption regarding the decision makers' perception of the prob-
abilities, i.e. the bettors need not be sophisticated as assumed by Rosett [6]. Nor is
it necessary to assume that decision makers are expected utility maximizers. In

4 Utilizing the definition of ah, a can be obtained from the identity,

h= (1+ah) 1-a
where ah are the odds on horse h to win a race and H is the number of horses in the race.
SAlthough the track-take and breakage vary from race to race and also from racetrack to racetrack,
their variability is negligible. The coefficient of variation of a in the above study was less than one per
cent.

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392 M. M. ALI

short, the conclusion of the paper does not depend on any specific valuation
process of the decision makers.6 This is a novelty not usually found in the works
dealing with market efficiency.

University of Kentucky

Manuscript received February, 1977; final revision received April, 1978.

REFERENCES

[1] ALI, M. M.: "Probability and Utility Estimates for Racetrack Bettors," Journal of Political
Economy, 85 (1977), 803-816.
[2] BAUMOL, W. J.: The Stock Market and Economic Efficiency. New York: Fordham University
Press, 1965.
[3] KEYNES, J. M.: The General Theory of Employment Interest and Money. New York: Harcourt,
Brace and Co., 1935.
[4] MOSTELLER, F., AND P. NOGEE: "An Experimental Measurement of Utility," Journal of
Political Economy, 59 (1951), 371-404.
[5] PRESTON, M. G., AND P. BARAITA: "An Experimental Study of the Auction-value of an
Uncertain Outcome," American Journal of Psychology, 61 (1948), 183-193.
[6] RoSETT, R. N.: "Gambling and Rationality," Journal of Political Economy, 73 (1965), 595-607.
[7] "Weak Experimental Verification of the Expected Utility Hypothesis," Review of
Economic Studies, 37 (1971), 481-492.

6The discounted future earnings of a stock is often viewed as its value. There are numerous ways to
make this valuation process operational. Any test for market efficiency relying on such an arbitrary
valuation process is questionable because the failure of a market in the efficiency test can be ascribed to
the possible invalidity of the postulated valuation model.

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