Pricing combinatorial markets for tournaments

Abstract

In a prediction market, agents trade assets whose value is tied to a future event, for example the outcome of the next presidential election. Asset prices determine a probability distribution over the set of possible outcomes. Typically, the outcome space is small, allowing agents to directly trade in each outcome, and allowing a market maker to explicitly update asset prices. Combinatorial markets, in contrast, work to estimate a full joint distribution of dependent observations, in which case the outcome space grows exponentially. In this paper, we consider the problem of pricing combinatorial markets for single-elimination tournaments. With $n$ competing teams, the outcome space is of size 2n-1. We show that the general pricing problem for tournaments is P-hard. We derive a polynomial-time algorithm for a restricted betting language based on a Bayesian network representation of the probability distribution. The language is fairly natural in the context of tournaments, allowing for example bets of the form "team i wins game k". We believe that our betting language is the first for combinatorial market makers that is both useful and tractable. We briefly discuss a heuristic approximation technique for the general case.