Noise, Information, and the Favorite-Longshot Bias in Parimutuel Predictions

According to the favorite-longshot bias, longshots are overbet relative to favorites: the expected return on an outcome tends to increase in the fraction of bets laid on that outcome. We propose an information-based explanation for this bias (and its reverse) in parimutuel markets. The bias arises because bettors take positions with- out knowing the positions simultaneously taken by other privately informed bettors. The direction and the extent of the bias depend on the amount of private information relative to noise present in the market. The comparative statics predictions of the model are in line with evidence from parimutuel games.