First: We should not be surprised that those markets “underprice high probability events and overprice low probability events”. This is a consequence of continuous information arrival. Any binary option MUST show this behaviour, mathematically, depending on its In-the-money or Out-of-the money state.

In the framework of Price Information Theory, with continuous information arrival, you “lose” probability until the prediction horizon sigma sqrt T of the price differential. No “irrationality” there. (Remember: “Austrians” start on the premise that man is rational.)

Second: The immediate analogy from such binary contracts to behaviour of securities markets is not permissible. Securities markets price discounted future cash-flows in consideration of the two risks (ex-ante volatility and noise) affecting them. Applying the problematic binary framework to securities prices does not make binary options a security, they stay what they are. (Price predictions on rice in China does not make them edible.)

Third: Based on this, it is easy to explain why the conclusions of the paper appear overdrawn: The better the probability of a binary follows the information decay, the more mispricing the presented model would detect. Mr. Tetlock final thoughts appear to run in a similar vein by stating in the end that “…, liquidity may only appear to be a priced risk factor because it captures some systematic element of mispricing.”

So: On this one, let’s stay with the cited conventional models (Kyle) plus some empirical evidence from “real” securities markets: Mispricing is greater in illiquid markets.

Hubertus Hofkirchner