Prices of State Contingent Claims with Insider Traders, and the Favourite-Longshot Bias

Abstract

This paper examines the pricing of state contingent claims in the presence of insider traders. The specific setting is the market for bets in a horse race in which bookmakers compete in prices in anticipation of betting from a group of bettors, some of whom have insider information. The author identifies a condition which is necessary and sufficient for the so called "favorite-bias" in which, the prices on the favorites understate the winning changes of these horses relatively less than the prices on the longshots. The robustness of this result is examined in a more general framework, and the bias is shown to survive in a generalized form. Copyright 1992 by Royal Economic Society.