Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

Abstract

This paper analyzes how asset prices in a binary market react to information when traders have heterogeneous prior beliefs. We show that the competitive equilibrium price underreacts to information when there is a bound to the amount of money traders are allowed to invest. Underreaction is more pronounced when prior beliefs are more heterogeneous. Even in the absence of exogenous bounds on the amount traders can invest, prices underreact to information provided traders become less risk averse as their wealth increases. In a dynamic setting, price changes are positively correlated over time. Thus the initial underreaction is followed by momentum.