The Wisdom of rationals

Excerpt;

For years now I have been fascinated by prediction markets. The source of excitement is the idea is that you can use financial markets to do inference — just like machine learning.

A famous example of such prediction markets are the orange futures. The orange futures market is one that allows entities to buy oranges in advance. How it works, is that one can pay $1,000 to receive 1,000 oranges that will be delivered next year. An interesting side effect of this orange futures market is how it accurately predicts temperatures in certain locations more specifically, the temperature of the locations where the oranges are from.

But how is information on temperature reflected in the market meant for selling oranges? Well, what actually happens, is that the orange futures prices rise towards cold weather and drop towards warm weather.

This phenomenon can be easily explained by the fact that cold weather reduces orange yields thus causing prices to rise (reasoning from the perspective of supply & demand). This explanation however doesn’t account for the fact that the market prices start reacting to temperature changes before they occur. It is as if the market knew what the temperature would be in the future. Hence the name prediction markets.

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