Keen, Byrnes — Prediction Market Derivatives: Arbitrage, Economic Utility, And Pricing

This paper analyzes the economic utility and pricing mechanisms of options on binary prediction market contracts. We derive a no-arbitrage condition proving that options expiring simultaneously with the underlying event are mathematically redundant, offering no leverage benefits beyond the underlying asset. Conversely, we demonstrate that Intermediate-Expiry Event Options (IEEOs)–-those expiring prior to event resolution–-complete the market by enabling the separation of volatility risk from outcome probability. We propose a Jump Diffusion pricing model to account for the discontinuous information flow characteristic of prediction markets and identify collateral inefficiencies that currently inhibit market development.