How do Prediction Markets Work?
Prediction markets are openly traded markets in which the assets being traded represent potential outcomes of a future event.
The most common prediction market trades only two outcomes on an event: “Yes” or “No”. This means that traders are betting on whether an event happens or it does not. These markets are sometimes known as binary markets since they only trade two distinct outcomes.
When a prediction market resolves, it requires an oracle to report the outcome of the event that happened in the real world. We assume for now that the oracle is trusted (although in a later article I will describe how to cope with untrusted oracle sources). For whatever outcome the oracle reports, the asset representing that outcome will be redeemable for 1 unit of currency.
If the market is denominated in USD then the outcome asset would be redeemed for $1.00, while if the market is denominated in a token such as ZTG than the asset would be redeemed for 1 ZTG. The rest of the article will use the example of ZTG since it’s Zeitgeist’s native currency.
On the other hand, the asset representing the outcome that did not happen would not be redeemable, since that outcome did not take place.
Knowing this, we can walk backwards and say that while the market is still trading (and the eventual real outcome of the event is unknown), that the complete set of outcome assets together are worth 1 ZTG. Since we know one or the other of them will be worth 1 ZTG in the end.
Now the interesting part comes in with how the traders value these assets while the market is open. Prediction markets are known to be excellent knowledge aggregation mechanisms, collecting diverse information from a vast amount of independent actors.
Each asset is related to each other with this mathematical formula:
Although this is basic, it allows us to make a key insight behind prediction markets, which is how we derive a probability from the price of the independent asset.
Since we know that the outcome of one of the outcomes happening is 100%, we can derive the probability of the event resolving to any particular outcome at any time to the price of the asset.
If Price_YES at some point in time is trading at price 0.6 ZTG this means that the market is predicting the likelihood of that event happening at 60%. Consequently, the market predicts that the NO outcome has 40% probability.
Now let’s say a trader comes along that has knowledge that the event is more likely than 60% chance to resolve to YES. This trader is now incentivized to correct the prediction market’s valuations by purchasing the YES asset closer to the individual’s personal estimation of that event’s likelihood.
In a nutshell this is how prediction markets work. This article we described only the most basic of prediction markets, the binary market. In future articles we will describe markets that trade on more than 2 outcomes, or even trade on ranges of outcomes.
Zeitgeist is an evolving blockchain for prediction markets and futarchy. It is a platform for open prediction markets as well as the protocol that governs the platform itself. Powered by the native currency, the ZTG, it embarks on a novel form of governance known as futarchy in order to govern itself as well as other organizations in the future. More information can be found on our homepage or by following the project on Twitter.
