Prediction Markets Say McCain Will Win! No Wait. Actually, It's Obama!

***CORRECTION***

In the original version of this post, I assumed that the Iowa Electronic Market contract was for the winner of the presidential election, but as a reader pointed out (luckily twice because the first time I stupidly maintained that I was right), the winner of the IEM contract is the candidate who gets the most votes and not necessarily wins the electoral college. That means that the Intrade contract -- which is an electoral vote contract -- can't strictly be compared to the IEM one as I have done below.
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Over at Intrade, traders, just like the rest of us, have been caught off-guard by the Palin phenomenon and have sent John McCain's contract up from about 37 at the start of the Democratic Convention to a high of 51.4 yesterday. That means that McCain has a better than 50 percent shot of winning the election, according to these traders.

At the Iowa Electronic Market, action has been much more subdued with McCain's contract climbing from 40 to 44 over the same time period. Traders here think Obama's got the goods.

The big difference between these markets seems to be volume. For Wednesday, 29,642 McCain contracts were traded while on the IEM it was 3,869 contracts (that's actually for the Tuesday, there were no trades listed for Wednesday). The volume discrepancy is similar for Obama contracts.

So the liquidity advantage means that Intrade's contract is more efficient and a better picture of reality, right? Not quite.

A recent paper by Paul Tetlock of Columbia University finds that more liquid prediction markets are associated with less efficient outcomes, a.k.a., wrong predictions. Tetlock writes:

I find that liquidity does not reduce--and sometimes increases--deviations of securities prices from financial and sporting event outcomes. Logically, prices can deviate from outcomes because average prices differ from average event outcomes (i.e., poor calibration), or because prices do not distinguish between events with different probabilities (i.e., poor resolution). I find that the prices of liquid securities are not better calibrated, and actually exhibit poorer resolution than the prices of illiquid securities.

...limit orders that passively execute during informative events have negative expected returns to expiration. This suggests that limit orders retard the response of prices to new information and thereby inhibit forecasting  resolution. Second, limit orders traders passively buy low-priced securities--e.g., $4 and below--and sell high-priced securities--e.g., $6 and above. Such limit orders could sustain the overpricing of low-priced securities and the underpricing of high-priced securities, a pattern known as the favorite-longshot bias...This second finding identifies a mechanism for how prices in liquid markets could remain more poorly calibrated than prices in illiquid markets.

• Larry Summers' Bailout Blues
• Welcome to Hollywood. Give us Your Wallet
• Lehman's End Game