Chapter 4 Quiz

Test your understanding of prediction market contracts, payoffs, order types, and settlement mechanics. Try to answer each question before revealing the answer.

Question 1

A binary contract pays $1 if the event occurs and $0 if it does not. If you buy a Yes contract at $0.72, what is your profit if the event occurs?

  • (A) $0.72
  • (B) $0.28
  • (C) $1.00
  • (D) $1.72
Answer **(B) $0.28** Profit = Payoff - Purchase Price = $1.00 - $0.72 = $0.28. You paid $0.72 and received $1.00, netting $0.28.

Question 2

In a well-functioning binary contract market with no overround, if Yes is priced at $0.58, what should No be priced at?

  • (A) $0.58
  • (B) $0.42
  • (C) $0.38
  • (D) $1.00
Answer **(B) $0.42** The no-arbitrage condition requires P(Yes) + P(No) = 1. Therefore, P(No) = 1 - 0.58 = 0.42.

Question 3

If Yes is priced at $0.55 and No is priced at $0.50 on the same contract, the overround is:

  • (A) 5%
  • (B) 5 cents
  • (C) -5%
  • (D) 10%
Answer **(B) 5 cents (or equivalently, 5 percentage points)** Overround = P(Yes) + P(No) - 1.00 = 0.55 + 0.50 - 1.00 = 0.05. This is 5 cents per pair of contracts, or a 5% overround.

Question 4

Selling (shorting) a Yes contract at $0.60 is economically equivalent to:

  • (A) Buying a Yes contract at $0.40
  • (B) Buying a No contract at $0.40
  • (C) Selling a No contract at $0.60
  • (D) Buying a Yes contract at $0.60
Answer **(B) Buying a No contract at $0.40** Shorting Yes at $0.60 gives you: +$0.60 if No, -$0.40 if Yes. Buying No at $0.40 gives: +$0.60 if No (payoff $1 minus cost $0.40), -$0.40 if Yes (payoff $0 minus cost $0.40). The payoff profiles are identical.

Question 5

In a multi-outcome market with 6 candidates, the prices sum to $1.08. What is the overround?

  • (A) 8 cents
  • (B) 8%
  • (C) Both (A) and (B) are correct
  • (D) $0.18
Answer **(C) Both (A) and (B) are correct** Overround = $1.08 - $1.00 = $0.08 = 8 cents = 8%. The overround is the amount by which the sum of prices exceeds $1.00.

Question 6

To normalize prices in a multi-outcome market to implied probabilities, you:

  • (A) Subtract the overround equally from each price
  • (B) Divide each price by the sum of all prices
  • (C) Multiply each price by the number of outcomes
  • (D) Subtract each price from 1
Answer **(B) Divide each price by the sum of all prices** Normalized probability = price_i / sum(all prices). This removes the overround proportionally and ensures the probabilities sum to 1.

Question 7

Arrow-Debreu securities are significant because:

  • (A) They are the cheapest contracts to trade
  • (B) Any complex payoff can be replicated by combining them
  • (C) They eliminate all market risk
  • (D) They guarantee positive returns
Answer **(B) Any complex payoff can be replicated by combining them** A complete set of Arrow-Debreu securities (one for each state of the world) can span any desired payoff structure. This is the key theoretical insight — prediction market contracts for each outcome form a complete set.

Question 8

A bracket scalar contract for GDP growth has a "2% to 3%" bracket priced at $0.35. This means the market implies:

  • (A) GDP growth will be exactly 2.5%
  • (B) A 35% probability that GDP growth falls between 2% and 3%
  • (C) GDP growth will be at least 2%
  • (D) The expected GDP growth is 3.5%
Answer **(B) A 35% probability that GDP growth falls between 2% and 3%** Each bracket in a scalar contract is a binary contract that pays $1 if the outcome falls within that range. A price of $0.35 implies a 35% probability for that bracket (before adjusting for overround).

Question 9

A linear scalar contract has floor = 0%, ceiling = 10%, and current price = $0.40. What is the implied expected value?

  • (A) 4%
  • (B) 40%
  • (C) $0.40
  • (D) 6%
Answer **(A) 4%** Implied expected value = price x (ceiling - floor) + floor = 0.40 x (10 - 0) + 0 = 4.0%. The price of a linear scalar contract directly encodes the expected value (normalized to the range).

Question 10

For a linear scalar contract with floor = 2% and ceiling = 8%, if the actual outcome is 5%, what is the payoff?

  • (A) $0.50
  • (B) $0.83
  • (C) $0.625
  • (D) $5.00
Answer **(A) $0.50** Payoff = (actual - floor) / (ceiling - floor) = (5 - 2) / (8 - 2) = 3 / 6 = 0.50.

Question 11

Which stage of the trade lifecycle comes immediately after order matching?

  • (A) Settlement
  • (B) Position held
  • (C) Resolution
  • (D) Research
Answer **(B) Position held** The lifecycle is: Research -> Order Placement -> Order Matching -> **Position Held** -> Resolution -> Settlement. After your order is matched, you hold a position that you can monitor and manage.

Question 12

A market order guarantees:

  • (A) The best possible price
  • (B) Execution (if liquidity exists)
  • (C) No slippage
  • (D) A profit
Answer **(B) Execution (if liquidity exists)** A market order prioritizes speed of execution over price. It will fill at whatever prices are available in the order book, which means it guarantees execution but not a specific price. It may experience slippage in thin markets.

Question 13

A limit buy order at $0.45 will execute only when:

  • (A) The market price is exactly $0.45
  • (B) A seller offers at $0.45 or lower
  • (C) A seller offers at $0.45 or higher
  • (D) The next trade in the market is at $0.45
Answer **(B) A seller offers at $0.45 or lower** A limit buy specifies the maximum price you are willing to pay. It will match against sell orders at your limit price or better (lower). If no sells are available at or below $0.45, the order rests in the book.

Question 14

The bid-ask spread in a prediction market order book represents:

  • (A) The platform's explicit fee
  • (B) The cost of immediate execution
  • (C) The contract's probability
  • (D) The overround
Answer **(B) The cost of immediate execution** The spread is the difference between the best bid (highest buy price) and the best ask (lowest sell price). If you want to trade immediately, you must cross the spread — buying at the ask or selling at the bid. The spread is the implicit cost of immediacy.

Question 15

An order with "Fill-or-Kill" (FOK) time-in-force will:

  • (A) Stay in the order book indefinitely
  • (B) Fill partially and cancel the rest
  • (C) Fill entirely immediately or be cancelled entirely
  • (D) Fill at the market close
Answer **(C) Fill entirely immediately or be cancelled entirely** FOK requires the full quantity to be filled in a single match. If the full quantity is not available at the specified price, the entire order is cancelled — no partial fills.

Question 16

You buy 60 contracts at $0.30 and 40 contracts at $0.50. Your average cost basis is:

  • (A) $0.40
  • (B) $0.38
  • (C) $0.35
  • (D) $0.42
Answer **(B) $0.38** Average cost = (60 x $0.30 + 40 x $0.50) / (60 + 40) = ($18 + $20) / 100 = $38 / 100 = $0.38.

Question 17

If your average cost basis is $0.45, you hold 100 contracts, and the current market price is $0.60, your unrealized P&L is:

  • (A) $15.00
  • (B) +$15.00
  • (C) -$15.00
  • (D) $60.00
Answer **(B) +$15.00** Unrealized P&L = (Current Price - Avg Cost) x Quantity = ($0.60 - $0.45) x 100 = +$15.00. The position has gained $15 in unrealized (paper) profit.

Question 18

The margin requirement for a short position on a Yes contract sold at $0.70 is:

  • (A) $0.70 per contract
  • (B) $1.00 per contract
  • (C) $0.30 per contract
  • (D) $0.00 per contract
Answer **(C) $0.30 per contract** When you short Yes at $0.70, your maximum loss is $1.00 - $0.70 = $0.30 (if the event occurs, you must pay $1.00 but only received $0.70). The platform holds $0.30 as margin to cover this potential loss.

Question 19

A contract resolves as "N/A" (voided). What happens to position holders?

  • (A) All contracts pay $1
  • (B) All contracts pay $0
  • (C) Contracts are refunded at the purchase price
  • (D) The platform keeps all the money
Answer **(C) Contracts are refunded at the purchase price** When a contract is voided (N/A resolution), the event is considered unadjudicable. All participants receive their purchase price back, as if the trade never happened.

Question 20

Which of the following is the BEST resolution criteria for a binary contract?

  • (A) "Resolves Yes if inflation is high"
  • (B) "Resolves Yes if the economy improves"
  • (C) "Resolves Yes if the BLS reports CPI year-over-year change >= 3.0% for March 2026 in the initial release"
  • (D) "Resolves Yes if most people think inflation went up"
Answer **(C) "Resolves Yes if the BLS reports CPI year-over-year change >= 3.0% for March 2026 in the initial release"** This is the best criteria because it specifies: (1) the exact metric (CPI year-over-year change), (2) the threshold (>= 3.0%), (3) the time period (March 2026), (4) the source (BLS), and (5) which release to use (initial, not revised). The other options are ambiguous, subjective, or undefined.

Question 21

You buy Yes at $0.50 on a platform with a 2% trading fee and a 5% winner's fee. What is the break-even probability?

  • (A) 50.0%
  • (B) 52.0%
  • (C) 53.7%
  • (D) 57.0%
Answer **(C) 53.7%** Break-even probability = [price x (1 + trade_fee)] / (1 - winner_fee) = [0.50 x 1.02] / [1 - 0.05] = 0.51 / 0.95 = 0.5368... which rounds to 53.7%.

Question 22

Slippage is best described as:

  • (A) The platform's explicit trading fee
  • (B) The difference between expected execution price and actual execution price
  • (C) The time delay between placing and filling an order
  • (D) The overround in a multi-outcome market
Answer **(B) The difference between expected execution price and actual execution price** Slippage occurs when a trade executes at a different price than expected, usually because the order consumes liquidity at multiple price levels in the order book. It is a function of order size relative to available liquidity.

Question 23

If you buy 100 contracts of each of 5 outcomes in a multi-outcome market where prices sum to $0.97, what is your guaranteed profit?

  • (A) $0
  • (B) $3
  • (C) $97
  • (D) There is no guaranteed profit
Answer **(B) $3** You spend 100 x $0.97 = $97 total. Exactly one outcome wins, paying you 100 x $1 = $100. Guaranteed profit = $100 - $97 = $3. When prices sum to less than $1, buying all outcomes creates a risk-free arbitrage.

Question 24

A trader holds 300 Yes contracts with average cost $0.40. She sells 100 at $0.55 and the contract then resolves Yes. What is her TOTAL P&L (realized from the sale + settlement of remaining contracts)?

  • (A) $135
  • (B) $105
  • (C) $135
  • (D) $135

Let me rewrite this more carefully:

  • (A) $105.00
  • (B) $135.00
  • (C) $120.00
  • (D) $95.00
Answer **(B) $135.00** Realized P&L from selling 100 at $0.55: (0.55 - 0.40) x 100 = $15.00. Remaining 200 contracts settle at $1.00: (1.00 - 0.40) x 200 = $120.00. Total P&L = $15.00 + $120.00 = $135.00. Alternatively: total revenue = (100 x $0.55) + (200 x $1.00) = $55 + $200 = $255. Total cost = 300 x $0.40 = $120. Net = $255 - $120 = $135.

Question 25

Which of the following is NOT a form of friction in prediction markets?

  • (A) Bid-ask spread
  • (B) Trading fees
  • (C) The no-arbitrage condition
  • (D) Withdrawal fees
Answer **(C) The no-arbitrage condition** The no-arbitrage condition (e.g., P(Yes) + P(No) = 1) is a theoretical pricing relationship, not a friction. Frictions are real costs that reduce a trader's profit: bid-ask spread (implicit cost of trading), trading fees (explicit cost), and withdrawal fees (cost of accessing your money). The no-arbitrage condition actually benefits traders by ensuring fair pricing.

Scoring Guide

Score Rating
23-25 Excellent — you have a strong grasp of contract mechanics
19-22 Good — review the topics you missed
15-18 Fair — re-read the relevant chapter sections
Below 15 Needs work — re-read the chapter and redo the exercises