Are prediction markets for hedging or prediction?

A common argument for prediction markets is that they would allow the hedging of risks that cannot be hedged in existing financial markets. Sometimes, however, forecasts produced by a prediction market can be used to avoid risk so that it doesn’t need to be hedged. Decision makers using a forecast in this way will typically need to subsidize the market. ?

Prediction markets use the mechanics of betting to elicit and combine the views of participants into forecasts that, in some sense, reflect the “wisdom of the crowd”. The name “prediction market” implies their primary purpose is to produce predictions but often, when such markets are discussed, another role is mentioned: “hedging”.

Hedging is a type of insurance: You bet that something will happen, not because you necessarily think that it will, but because winning the bet will compensate you for a loss you will suffer if it does happen. I might bet that it will rain on the day I am holding a garden party not because I think it will but because if it does rain my winnings will offset the money I’ve spent on catering.

It is argued that people seeking to hedge their risks can provide the liquidity needed to make prediction markets on esoteric topics work. Sometimes this is true, but a market with no hedgers could still be useful by providing predictions that allow risks to be avoided altogether, rather than transferred to someone else.

...the value of the prediction market can be the prediction that it provides, not the opportunity it gives to hedge risk.

If I have a weather forecast that is accurate enough, and has a long enough lead time, I can schedule my garden party for a day when there is very little chance of rain. This is preferable to taking a risk, even if I am able to hedge the risk; I can avoid the real economic loss of a rained-off party. In this case, the value of the prediction market can be the prediction that it provides, not the opportunity it gives to hedge risk.

By allowing reduction in real economic losses, using prediction markets for prediction can be more socially useful than using them for hedging. Hedgers, however, are a source of liquidity and provide incentives for other participants to inject good information into the market. Without hedgers these incentives must come from elsewhere, such as market sponsors who don't mind paying for a forecast, contingent on its accuracy.

Many climate-related risks could be reduced with good planning. We can avoid building in areas likely to become more flood prone, design new infrastructure to be more resilient to hotter summers, and so on. These kinds of decisions aren’t about transferring risk, they are about trying to minimize it, but they require good forecasts of what the risks are and where they’ll appear. Many of the risks associated with climate change will ultimately be the responsibility of governments who might not be able or even want to transfer them. This makes taking decisions to minimize them more important. Prediction markets can assist risk avoidance by allowing prediction to be decoupled from hedging. But, when hedger are absent, decision makers cannot expect to get forecasts for nothing so will have to subsidize the market.