In this talk I will overview my research on strategic forecasting and prediction markets. In the first part of the talk, I will present two theories of professional forecasters’ strategic behavior. The first theory, reputational cheap talk, posits that forecasters endeavor to convince the market that they are well informed. The market evaluates their forecasting talent on the basis of the forecasts and the realized state. If the market expects forecasters to report their posterior expectations honestly, then forecasts are shaded toward the prior mean. With correct market expectations, equilibrium forecasts are imprecise but not shaded. The second theory posits that forecasters compete in a forecasting contest with pre-specified rules. In a winner-take-all contest, equilibrium forecasts are excessively differentiated.

In the second part of the talk, I will introduce my work on information aggregation in prediction markets. In the context of a simple model of a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price underreacts to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first-period price is followed by momentum.

The talk will be based on different papers of mine available for download on my web page:
http://www.kellogg.northwestern.edu/Faculty/ottaviani/homepage/