We analyze the impact that transaction costs have on asset mispricing in state-contingent claims markets. In particular, we examine betting markets, in which, it has been argued, transaction costs cause the favorite-longshot bias, a pricing anomaly analogous to the volatility smile in options...

Finding what causes pricing anomalies is an important step towards improving market efficiency. The favourite-longshot bias is one of the longest-standing pricing anomalies in state-contingent claims markets. However, existing models are unable to capture its full complexity. We develop a...