Introduction to the Elficiencv of Exotic Waeering Markets

Donald B. Hausch, Victor S.Y. Lo and William T. Ziemba

Exotic bets are wagers involving two or more horses, and a variety of them are offered by tracks.
Quinellas require one to predict the first two finishers in a race. Exactas (or perfectas) also require one
to predict the first two horses in a race, but additionally one needs to predict their order of finish. The
trifecta involves naming the first three finishers in the correct order. In a double (or daily double) bet,
one must select the winner of two consecutive races. The double concept has been extended to predicting
winners of three, four, six, and more consecutive race, providing the public extremely low probability
but high payoff wagers. This section is concerned with the efficiency of these markets.

Exotic wagers tend to be very popular with the public. Part of the attraction is their risk/return
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tradeoff; one wins with very low probability but the payoff is high. in view of the favorite-longshot bias
for win bets, it is not surprising that longer-odds events than win bets are heavily wagered. Benter
(1994)' provides another reason for the exotics' lure. To illustrate his reason, consider double betting,
which bettors can create for themselves by wagering on a horse and then, if successful, betting to win
all the proceeds of the first race on a horse in the next race. This self-constructed double bet, called a
parlay, does differ from a double in an important way. The double involves incurring the track take just
once. The parlay, however, involves a track take on both of its win bets. Thus, the transactions costs
are higher with the self-constructed exotic bets. Benter's (1994)' point is that in order to be a successful
bettor, one needs handicapping skills exceeding those of the average bettor. For win betting, to cover
the track take, one's skills must be significantly better than average. Exotic betting, however, due to its
"lower" transactions costs, requires less of a skill advantage for a bettor to be profitable. Many tracks
account for this difference by charging a higher track take on exotic wagers, reducing its advantage. The
same phenomenon is in betting on lottos with unpopular numbers. The more numbers (races) there are
the easier it is to win, see Ziemba, Brumelle, Gautier and Schwartz (1986)? and McLean, Ziemba and
Blazenko (1992)l.

While a parlay that is a self-constructed version of a double pays the track take twice, it does
allow the bettor more information. The double itself must be made before either race; thus, a bettor sees
the public's odds on the first race but has little information about the public's view of the second race
(other than any information that can be gleaned from the payoffs that are offered on double combinations,
but that information is usually difficult to access). The parlay allows one to wager on the second race
with a better sense of the public's impression of the horses. Ali (1979)' found that returns of parlays and
double bets were not significantly different. Thus, they are "equally priced," an implication of an
efficient market. Asch and Quandt (1987)', however, found that doubles are statistically more profitable
than parlays. When parlay payoffs are adjusted as if parlay bettors paid the track take just once, then
returns on parlays and doubles are not significantly different. Lo and Busche's (1994)' conclusions were
the same for Hong Kong data. Their results also indicate that bettors bet on double and double quinella
less accurately when compared to the win bet using data from Meadowlands and Hong Kong.

Asch and Quandt (1987)' find some support for the notion that "smart money" is in the exotic
pools. The basis for this notion is that the informational content of smart money is more difficult for the
public to discern in the exotic market than it would be if it were wagered in the win market. Their
analysis ignores the systematic biases of the Harville (1973)' model, though. Also, Dolbear (1991)'
describes a further bias in their comparison of the theoretical and subjective probabilities of exacta
outcomes. Bacon-Shone, Lo and Busche (1992)? address these concerns and conclude that the public's
exacta betting provides more accurate estimates of ordering probabilities (the probability that i wins and

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by Harville (1973)', Henery (1981)' or Stern (1990)3. Similarly, the trifecta market provides more
accurate estimates of their ordering probabilities than does the win market.

Hausch, Lo and Ziemba (1994)' develop a general formula for optimal betting on exotic bets.
Their model allows ordering probabilities based on Harville (1973)', Henery (1981)' or Stern (1990)' with
the help of approximations developed by Lo and Bacon-Shone (1993)'. The model employs the Kelly
criterion and can be applied to any exotic bet. Quinella data on 369 Hong Kong races is used to illustrate
the system. Benter (1994)' proposes another way of modifying the Harville model.

Kanto and Rosenqvist (1994)' develop a betting system for quinella bets (called double bets in
Finland) at a Finnish racetrack. Instead of using the win odds data directly, they use maximum likelihood
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estimation and the Harville (1973)' model to estimate the win probabilities and the probabilities associated
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with a quinella bet by assuming that the quinella bet amounts for different combinations follow a
multinomid distribution. Using the Kelly criterion for wagering and 111 races, they show some evidence
of positive profits.

Post positions for horses are normally assigned in a random fashion. There are circumstances,
such as for a front runner, where an inside post position can be an advantage. Canfield, Fauman and
Ziemba (1987)' consider any post position bias in assessing the efficiency of win and exotic markets.
Using a three year Canadian data set, their results indicate that inside post positions provide a winning
edge and outside positions are disadvantageous. Furthermore, the bias is more pronounced the smaller
the circumference of the track (because turns - where the advantage of the inside positions lies - tend to
be a greater fraction of the distance covered) and the longer the race (because such races tend to involve
more turns). However, after accounting for transactions costs, the public overbets the favorable bias
positions to fully negate their advantage, and thus over the long run the bias provides no financial
advantage. Because tracks are banked, water may accumulate near the rail when it rains. Canfield,
Fauman and Ziemba found that such off track days introduce an effect that essentially neutralizes the bias
in favor of post position one. The public seems not to completely appreciate this, though, as wagering
on post position one on off track days generates significant losses. For off tracks, a favorable bias does
persist for positions two and three, though, which seems to allow an advantage in exotic wagering.

Using more recent data from the racetrack studied by Canfield, Fauman and Ziemba (1987)',
Betton (1994)' employs a probit analysis and pooled cross-sectional time series analysis to study the post
position bias. She models the relationship between the odds ranking, post position, and final position of
a horse. The length of the race does not significantly improve the fit of any of these models. Her results
indicate that the post position significantly adds to the information available from the odds rankings in
determining the probability of a horse placing in the top three positions. She also shows that as the
number of horse in a race increases, the post position bias becomes a more important factor in addition
to the win odds.

' included in this volume

cited in the Annotated Bibliography