3.

a) A winner-takes-all contract that costs $p and pays off $1 if and only if a specific
event occurs will elucidate the probability of the event occurring, assuming risk-
neutrality.
An index contract that pays according to the value of a certain number that varies
continuously should cost the mean value of this number.
A spread bet costs a fixed amount and pays a predetermined amount if the bettor
wins but $0 if the bettor loses. The bettors choose the cutoff y* at which they are willing
to make the bet. For example, if the contract costs $1 and the payoff is $2 in the good
case and $0 in the bad case, then y* will be the median value of the bet.

b) Favorite-long shot bias is a betting phenomena in which very unlikely bets (long
shots) are overpriced and the most likely bets (favorites) are underpriced. This occurs
because bettors are bad at predicting the likelihood of an event with a small probability
and thus tend to overestimate.
If markets showed equal bias, then the bid and ask prices on Tradesports would
correspond with estimated prices from actual S&P options. However, in such
comparisons, Wolfers and Zitzewitz see that bettors on Tradesport slightly overvalue
unlikely bets and undervalue most likely bets compared to estimates from actual
December S&P options. They interpret it as the inability of investors to correctly value
small bets, as well as a certain irrationality of bettors who trade according to their desires
under certain situations.

c) Saturday, Oct 27 - 4:02PM

P(nominated) P(elected) Implied

P(elected | nominated)
Giuliani 42.5 17.6 0.414117647
Romney 26.2 8 0.305343511
Thompson 11.4 5.1 0.447368421

According to Bayes formula,

P(elected | nominated) = P(nominated | elected) * P(elected) / P(nominated)
However, since we know P(nominated | elected) = 1, this simplifies to
P(elected | nominated) = P(elected) / P(nominated)

d) Not necessarily, because the results from part (c) do not imply causality, simply
correlation. Thus, the results reflect the popular sentiment on the chances of each
candidate winning given their performance on the primary. For example, an underdog in
the primary may have a higher probability in part (c) of winning; this may reflect an
understanding that if the candidate is so effective in winning over the public in the
primary as to win the primary, then that candidate would fare much better in the actual
election than the current favorite. However, making the underdog the best-funded
candidate will help them bypass the selection process when they are not actually as
qualified.
4. a) The probability that the Red Sox will win can be proxied by the price of each
“lot,” or the security that pays $100 in the case that the Red Sox win the World Series.
The probability increases slowly over the last few months, spikes to about 40% in early
October, fluctuates, and rises to about 68% the day before the first game is played.
Surprisingly, it remains at this level through the first two games and jumps ~12% the day
after the second Red Sox win and keeps jumping up, to 87% the next day and 96% on the
day the Red Sox win the World Series.

b) If information is revealed only during games, then price jumps should happen
only after games and not before.

c) The implied probability of the Red Sox winning the World Series would update
after each game because after the result of each game is revealed, the event that the Red
Sox win that game is no longer a random variable; thus, the probability that the Red Sox
will win the World Series is the probability that, going forward from that point, the Red
Sox will win the requisite number of games out of the total games remaining.

For example, after the first game is played, the probability will either go up if the
Red Sox win, or go down if the Red Sox lose. At the next game, the same thing will
happen, until after the last game, the probability of winning is 1 or 0 depending on
whether they won or lost. The exact probabilities can be calculated; I will not do so on
this problem set since it’s a pretty time-consuming mechanical calculation.

As for whether the data from Tradesports are consistent with this model, it is hard
to say. Off the bat, if we use the data as exact proxies for the probabilities that the Red
Sox will win at each stage, then no, because the probabilities should go up after each
game and not before the series begins.
It’s probably a decent approximation of what actually happens if we assume that
no-one knows what that probability is; it’s an underlying probability that drives the game
but we may not discover it even when the game is over. For example, there may be a
more or less fixed probability that the Red Sox will win each game. However, each
bidder has a different assessment of what this probability is. Before the World Series
begins, there is a lot of speculation and variance of beliefs about what this underlying
probability is. After the first game, the variance of beliefs narrows but the expectation of
the underlying probability also changed; the two effects balance to keep the investors’
assessment of the probability that the Red Sox win the same. After the second game,
there is a great jump in prices because people believe that two wins in a row implies a
much smaller range of possible underlying probabilities. Consistent with the theory, the
valuations of winning rise until the series is finally won by the Red Sox.