Insider trading and bias in a market for state-contingent claims

This chapter aims to shed light on the functioning of a market for state-contingent claims with inside traders. Many markets are beset by clandestine and illegal insider activity, which much effort has been made to control. The Melbourne horse betting bookmakers' market considered in this chapter is unusual in that insider trading is legal there. In many markets for state-contingent claims, including most betting markets, a favourite-longshot bias is observed throughout, but decreases over time. In the context of a horse betting market, a favourite-longshot bias implies that favourites are underpriced relative to longshots. The explanations given in the literature for this common phenomenon, which is seemingly incongruent with market efficiency, are briefly summarised below for the case of bookmaking markets. Although the typical market for horse bets lasts 30 minutes at most, it goes through several phases with more than one set of prices, as explained below. The analysis presented in this chapter suggests new explanations for this phenomenon. In contrast to (legal) US horse betting markets, which are only parimutuel, betting on-course in Australia takes place with both a parimutuel and bookmakers. In parimutuel betting, the bettors on horses do not know the return odds until all betting is completed and the total revenue, minus tax and costs, is divided among the winners, proportionally to the bets made. Bookmakers, on the other hand, offer bets at fixed odds, which are more amenable to profitable exploitation by shrewd insiders.