The Suntory and Toyota International Centres for Economics and Related Disciplines

Efficiency and Profitability in Exotic Bets

Author(s): Peter Asch and Richard E. Quandt
Source: Economica, New Series, Vol. 54, No. 215 (Aug., 1987), pp. 289-298
Published by: Wiley on behalf of The London School of Economics and Political Science and
The Suntory and Toyota International Centres for Economics and Related Disciplines
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Economica, 54, 289-298

Efficiency and Profitability in Exotic Bets

BY PETER ASCH and RICHARD E. QUANDT

Rutgers University and Princeton University

Final version received 4 September 1986. Accepted 22 September 1986.

The efficiency and profitability of exotic racetrack bets such as exactas and daily doubles are
examined. Efficiency is understood to mean that above average returns cannot be made in
the long run once risk is appropriately controlled for. The markets in question are found not
to be efficient; the inefficiencies, however, are insufficient to permit simple strategies to show
a consistent profit. Some evidence of "smart money" exists in that holders of inside information
may bet on exactas rather than equivalent standard bets in order to avoid signalling their
actions to the betting public.

INTRODUCTION

The efficient markets hypothesis has found considerable empirical support in

studies of securities markets, where efficiency is taken to mean that consistently
above-average profits cannot be gained from investing-or at least that such
profits cannot be made once the differential risks of investment vehicles are
taken into account.
Investigation of the efficiency of gambling markets has focused on racetrack
betting. 'Efficiency' has often been interpreted as the inability to pursue a
betting strategy that yields a rate of return significantly above the average loss
to all bettors; this loss, which averages 17-21 per cent at US racetracks, is a
function of the track take on various types of bets.' Some investigato
that betting markets are reasonably efficient (Dowie, 1976; Snyder, 1978;
Figlewski, 1979; Ali, 1979), whereas other see significant departures from
efficiency (Asch, Malkiel and Quandt, 1982, 1984; Hausch, Ziemba and
Rubinstein, 1981; Ziemba and Hausch, 1984; Crafts, 1985; Zuber, Gandar and
Bowers, 1985). Generally, the findings of some inefficiency seem convincing
enough to suggest that complete efficiency is not the rule. Inefficiency, of
course, does not necessarily mean that racetrack betting is profitable. An
increase in the expected rate of return from -0-18 to -005, attributable to
some clever betting strategy, suggests inefficiency but does not imply
profitability.
In this paper we consider betting that occurs at the racetrack. Off-track
betting is permitted at some locations in the United States, but is far less
significant quantitatively than in Britain. Bets at US racetracks occur under a
pari mutuel system that calculates and continually updates betting odds based
on all wagers. Payoffs to all types of bets are based on the final odds that
prevail at the end of each betting period. Bettors thus have no opportunity to
contract for wagers at 'earlier' odds, and cannot be certain about the odds
that will govern the payoff to a successful bet.
If Wi is the amount of money bet on horse i, W is the total amount bet
on all horses in a race, t is the track take and pi is the objective probability
that horse i wins, the expected return to a bet is

W(1-t)
R = p-1.

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 290 ECONOMICA [AUGUST

If the bet is to have positive expected return, the proportion of all dollars bet
on the horse must not exceed pi(I - t). To devise a profitable betting strategy
thus requires the identification not only of winners, but of winners that the
betting public does not regard as winners.
This paper investigates the efficiency of a class of wagers known as 'exotic
bets'. The members of this class are compound bets, and require more compli-
cated estimates of outcomes than do the familiar win, place and show bets.
Because of the track take, all racetrack bets tend to have negative expected
returns.
Even if it is difficult to explain why individuals engage repetitively in such
a money-losing activity, it is interesting and important to examine whether
differential avenues to losing money tend to equalize rates of return. This is
the basic concern of the present paper. In Section I we characterize these bets
and the data to be employed. In Section II we formulate our hypotheses
concerning exactas and present our analysis of the data. Section III proceeds
analogously with respect to daily doubles. Section IV presents an explanation
of a discrepancy between the exacta and daily double findings. Some brief
conclusions are presented in Section V.

I. EXOTIC BETS AND DATA SOURCES

The standard racetrack wagers are win, place and show bets. The minimum
bet is usually $2, and a win bet on horse i is successful if and only if horse i
wins the race. In this case, the payoff per dollar bet is W(1 - t)/ Wi, where
the terms are as defined above. A place bet on horse i is successful if horse i
comes in first or second; and a show bet is successful if horse i comes in first,
second or third.2
Exotic bets involve at least two simultaneous wagers on different horses.
In this paper, we investigate the exacta and the daily double. In the exacta,
the bettor must pick two horses: one to win and one to come in second. The
bet is successful if both picks are correct, and is unsuccessful otherwise. In
the daily double, the bettor picks the winners of two consecutive races; the
bet is successful if both picks win, and is unsuccessful otherwise. The racetrack
designates the races in which such betting is available.
It is obvious that the exotic bets are relatively low-probability wagers. Since
the track take also tends to be higher on exotic bets,3 these bets should appeal
to relative risk-lovers. Perhaps the most widely established empirical regularity
in racetrack gambling concerns win bets: horses with low probabilities of
winning ('long shots') are overbet; and horses with high probabilities of
winning ('favourites') are underbet. That is, the proportion of all moneys bet
on long shots is greater than their objective winning probability, with the
reverse holding for favourites (Rosett, 1965, 1971; Snyder, 1978; Ali, 1979;
Asch, Malkiel and Quandt, 1982). As a result, rates of return are higher for
favourites than for long shots.
Whether a similar pattern ought to be expected for exactas or daily doubles
is unclear. In straight win betting, one may easily distinguish between 'high-
probability' bets (with success probabilities of perhaps 03-06) and 'low-
probability' bets (in the range of 002-005). For exactas, however, the prob-
abilities of success may lie largely in the range 0O05-0O001; and we do not

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 1987] EFFICIENCY AND PROFITABILITY 291

know whether bettors clearly discriminate among probabilities in this narrow

range.
A second, and potentially more interesting, feature of exactas and daily
doubles is that (unlike win, place and show betting) the amounts wagered on
the various combinations are not continuously displayed at the track.4 This
may have important signalling consequences. If certain bettors are privy to
inside information ('smart money' is, of course, part of the folklore of racetrack
betting), it may be difficult to take advantage of this in straight win (and
perhaps in place or show) betting, because one's bet is immediately revealed
to the crowd, and may induce 'following' behaviour. This would drive down
the odds and prospective payoffs, thereby destroying the usefulness of the
inside information.
Such revelation is far less likely in exotic betting. Whereas a major dis-
crepancy in wagering might be spotted by a few bettors, the signal conveyed
to the crowd as a whole is almost always obscure. Thus, acting on inside
information via exotic bets is safer. However, it also incurs the cost of having
to bet on two or more horses simultaneously, while inside information may
be confined to the prospects of a single animal.
The data employed in this study comprise the results of harness racing
between 26 May and 11 August 1984 at the Meadowlands Racetrack. A total
of 705 usable races took place (we eliminated a small number of anomalies
such as the existence of two winners); exacta betting was available in 510 of
these, and daily double betting in 122 pairs of races.

II. ANALYSIS OF EXACTA BETrING

In a race with n horses, there are n (n - 1) different exacta bets. We denote by

Bij the amount bet by all bettors on the exacta that horse i will win and j will
run second in a given race. If B is the total amount bet on all exacta
combinations in the race and t is the track take, then the payoff to the
per dollar wagered, if successful, is

(1) Ajj = (1-t)B/Bij.

If hi, is the objective probability that the (ij)-exacta is successfu

value Eij and the variance Vij of return are

(2) E=A Ai1hi,-1

(3) Vij = (Aij - 1)2 hij + (I1 - hij ) - Eiij

The computation of these requires estimates of the objective probabilities, a
problem that we consider later. We first examine average rates of return to
various exactas.

Average rates of return

In analysing the profitability of straight win bets and the relationship of

profitability to the 'market's' assessment of winning probabilities, investigators
have often computed the actual average rates of return to horses in various
odds classes.5 In the case of exactas, there are no odds as such, but we can
categorize exactas by the value of the (potential) payoff A,i. The average r
of return in a class of A,, values is (AijS,j - 1)/ N, where S,j = 1 if the (ij)-exa

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 292 ECONOMICA [AUGUST

is successful and 0 otherwise, and N is the number of exactas over which the
average is taken.
The average rates of return to exacta bets show an erratic, if not random,
relationship with respect to payoff class.6 It is not surprising that some rates
of return are better than -0 19 (the track take) and not even surprising that
a few are positive; what is significant is that these better-than-expected rates
of return do not appear to be related to payoff class. Thus, we cannot confirm
the existence of a typical underbetting/overbetting bias.

Arbitrage and efficiency

The bets on various horses in the win pool define their subjective winning
probabilities and thus, implicitly, define the subjective success probabilities
for particular exactas. At the same time, the amounts bet on each possible
exacta combination divided by the total exacta pool provide a direct estimate
of the subjective success probabilities. If information is used consistently by
all bettors, the two 'markets' will be fully arbitraged and the two sets of
probabilities will be (statistically) the same.
To test whether this is so, we first compute the subjective winning prob-
abilities of each horse in each race from the straight win bets (subjective
probability si = Wi/ W). To obtain an estimate of the objective winning pr
abilities pi, we have aggregated horses into classes. We have 705 races which
contained 6729 horses; these were aggregated into 20 classes, with class 1
containing the 337 horses with the lowest si, class 2 the 337 horses with the
next lowest si, etc. (Some classes contain 336 horses.) For each of the 20
classes, we computed the mean of the subjective probabilities of the horses in
that class s1 , S2, ... , s20 and an estimate of the objective probabilities
Pi, ... *, P20, by determining the proportion of horses that actually won in each
class. These are displayed in Table 1, and confirm the existence of the familiar
underbetting/overbetting bias.
The average relationship between the objective and subjective probabilities
is now determined by regressing pi on si. The estimated equation is:

(4) p=-0 0100 + 1 09595

(-1-9965) (31.5177)

(parenthesized values denote t-statistics throughout), and R2 = 0 9803.7

The objective probability of success in the (ij)-exacta is then obtained as
follows. (1) Substitute in (4) the actual subjective probability of each horse,
si, and compute an estimate pi of the objective winning probability of that
horse. (2) Apply the Harville (1973) approximation to these pi to obtain an
estimate that horse i wins and horse j is second. This approximation is:8
A A

(5) h J=1^
1-Pi

Finally, obtain an estimate of the implicit subjective probability of success for

the (ij)-exactabyusing (4): substitute h1j = -00100+ 1-0959s5 andsolvefors*.
Of course, as already noted, a direct measure of the subjective probability
of success for the (ij)-exacta is given by sij = Bij/B. The key observation i
that, if the market is efficient, it must evaluate the winning and runner-up

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 1987] EFFICIENCY AND PROFITABILITY 293

TABLE 1

OBJECTIVE (pi) AND THE MEAN

SUBJECTIVE (si) WINNING
PROBABILITY ESTIMATES FOR
MEADOWLANDS DATA

Pi Si

0-0030 0-0068
0-0030 0-0110
0-0059 0-0151
0-0119 00201
00178 0-0258
0-0445 0-0323
0-0297 0-0398
0-0386 0-0489
0-0415 0O0581
00804 0-0683
0-0804 0-0787
00923 0-0908
0 1310 0-1036
01161 0-1185
0-1250 0-1368
0-1637 0-1587
01548 01841
0-2024 0-2220
0-3006 02747
0-4554 0-4031

chances of individual horses in mathematically consistent fashion; thus the

probability estimates sij and s*J must be the same pairwise, on average. This
hypothesis can be tested by regressing s* on sij in the equation

5*J = a + bsij + uij,

and testing Ho: a = 0, b = 1. The regression is based on 41,246 exacta pairs

and is:

s* = 0-00683 + 1-10267s,j
(186.374) (683-350)

R = 0-9190. The null hypothesis is thus rejected at all conventional significance

levels.

The 'smart money' hypothesis

Above we have compared the subjective probability estimates obtained from
the exacta pool with those implicit in the win pools. We can also compare the
payoffs to potential winners based on the exacta pool with those implicitly
given by the sij calculated from the win pool. The actual payoffs that wo
accrue to (potential) winners are:

(6) Aj = (1-t)B= (s-t)

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 294 ECONOMICA [AUGUST

The implicit payoffs, denoted by A*, are:

(7) A* = (1 *t).
A 'smart money' hypothesis can be tested by examining the differences A* - A11.
We group the differences for all 41,246 exacta pairs as follows: group I contains
the 51OAO - Aij values for exacta combinations that actually won, and gro
II contains the values for the remaining combinations.
Suppose that there are bettors with inside information. To avoid sending
clear signals, they utilize their information by betting on exactas. Whereas, in
the no-inside-information case, we would expect the distribution of differences
V - Aij to be statistically the same for groups I and II, the 'smart mone
hypothesis suggests that actual payoffs Aij will tend to be depressed relative
to A* for exacta winners (group I). The Kolmogorov-Smirnov test rejects the
hypothesis that the two distributions of A* - Aij values were drawn from the
same parent distribution.
The means and variances of the two groups are shown in Table 2. The
differences in means are highly significant and are in the direction predicted
by the 'smart money' hypothesis.

TABLE 2

MEANS AND VARIANCES FOR A*J-A FOR WINNING AND

LOSING EXACTA PAIRS

Winning Losing

No. of pairs 510 40,736

Mean AM -A^ -33 18 -261i69
Variance AJ -A 103-84 458*85

Efficiency in a mean-variance framework?

Since racetrack betting is an unfair game, then, barring non-economic motives,
racetrack bettors must be risk-lovers. Since mean return and variance are both
'goods' in this case, the indifference curves of the expected utility function
must have negative slope, as in the conventional case. For equilibrium to be
possible, it is necessary that the boundary of the feasible region, the 'mean-
variance locus', also have negative slope. This can be examined by computing
(2) and (3) for every exacta in every race and checking whether Ei, > EkI
and only if Vij ? Vkl. The facts are that in no race was the mean-varia
locus uniformly of the slope compatible with efficiency.

III. ANALYSIS OF DAILY DOUBLE BETTING

The daily double provides a straightforward comparison between the com-

pound (exotic) bet and the equivalent pair of single-horse bets. Consider
betting on a horse i in the first of two races and, if it wins, betting the entire
payoff on horse j in the second race. This bet, called a parlay, is in effect a
daily double bet. Both the daily double and the parlay are successful if and
only if both chosen horses win their respective races.

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 1987] EFFICIENCY AND PROFITABILITY 295

We now consider only winning daily double pairs. Their actual payoffs are
denoted by Dk (k = 1, . . . , 122). For each of these, we can also compute the
equivalent parlay payoffs, denoted by Lk. If the market is efficient, it should
not, on average, make any difference whether one bets a given pair of horses
via the daily double or a parlay.
This is not the case, however. The average of the daily double payoffs is
$52-54 and the parlay payoffs $41-38, suggesting that it is substantially more
profitable to bet on the daily double.9 The reason may well be that the
commitment to a daily double must be made before the start of the first of
two consecutive races, i.e., before the evolution of odds in race no. 2, which
may play an important role in revealing relevant information.
Since winning daily double combinations appear to be underbet, one must
suspect that a 'smart money' hypothesis is unlikely to be supported here. This
is indeed the case, when we compute the Dk -Lk differences for all daily
double pairs and group them as we did for exactas. The comparison between
the groups suggests the opposite of the 'smart money' hypothesis; that is, the
mean Dk - Lk is smaller for losing pairs than for winning pairs.10

V. THE DISCREPANCY BETWEEN EXACTAS AND DAILY DOUBLES

It is interesting to consider why the analysis of exacta and daily double betting
suggests diametrically opposed conclusions with respect to the 'smart money'
hypothesis. We suggest the following answer, based on considerations of
signalling.
If there are n, horses running in the first and n2 in the second race of a
daily double pair, the total number of potential daily double bets is n1n2. As
soon as the first race is over, the number of possible winning bets is reduced
to n2, since the winner of the first race is now known. Racetracks customarily
display, before the beginning of the second race, 'will pay' amounts-i.e., the
sums that would be paid to ticket-holders on each of the still-possible winning
combinations. These figures contain potentially important information.
Suppose that insider information has suggested to some bettors that horse
il in race 1 and horse 12 in race 2 are likely to win. The combination i1J-2 will
then be heavily bet by insiders in the daily double if, as we conjecture, they
attempt to hide their actions from the betting crowd. After the first race is
over, however, the 'will pay' figure allow the public at large to observe that
horse 12 in race 2 has been heavily bet in the daily double relative to the odds
that are evolving in the straight win betting for race 2. The signal that insiders
have hidden in the daily double betting is now revealed.
Racetrack bettors can no longer wager on the daily double; but they can
follow the signal that has emerged from the 'will pay' numbers by backing
horse 12 to win in race 2. Such betting will reduce the odds and winning payoff
to 12, and also will reduce the profitability of a parlay on combination i1j2.
In effect, bettors believe the 'smart money' hypothesis that we have suggested
above, and act accordingly.
There is some evidence that the following type of behaviour exists. Let f
denote the payoff to horse j in straight win betting, mj the payoff to j that
would occur on the basis of morning line odds, and zj some appropriate
measure of the payoff to j in daily double betting relative to the payoff based

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 296 ECONOMICA [AUGUST

on morning line odds such as their ratio. Since the morning line represents a
professional's estimate of the intrinsic quality of a horse, it will be positively
related to the final odds. If imitative (following) behaviour does occur, then
a relatively low z; will induce a relatively low value offj. Thus, in the regres
equation

f = cao+ a1lm + a2Z. + U;

where uj represents the error term, we expect, a priori, a1> 0, a2> 0. T
regression yields:

fj=-16-204 + 2d157mj+10470zj
(-20.503) (35 750) (27-000)

where R2 = 0-706. Qualitatively similar results emerge if z

ratio of payoffs but as a difference in payoff ranks, or if the regression equation
is run only over observations representing winning horses, or only over observa-
tions for losing horses.
Since the presence of imitative behaviour appears to be confirmed, we
would not expect parlays to be more profitable than daily double bets. It is
still not clear, however, why parlays are actually less profitable. One possibility
is that the public overreacts to the signal perceived in the will-pay figures, in
effect attaching too much weight to 'new' information. Such tendencies have
been observed in other settings by experimental psychologists (Kahneman and
Tversky, 1982); and there is plausible evidence of this sort of overreaction in
stock markets (de Bondt and Thaler, 1985). The patterns of betting that we
have described are clearly consistent with an overreaction phenomenon. The
issue, however, deserves fuller investigation.

V. CONCLUSION

Are pari mutuel markets for exotic bets efficient? And is inside information
('smart money') a verifiable source of any observed inefficiency? Our analysis
of two types of exotic bets, exactas and daily doubles, yields the following
conclusions. (1) Both of these betting markets exhibit inefficiency in the sense
that their payoffs are not statistically the same as the payoffs to the analogous
bets on individual horses; in addition, the mean-variance locus of exacta
combinations is inconsistent with efficiency for risk-loving bettors. (2) The
differences in payoffs support the 'smart money' hypothesis for exacta betting,
but not for daily double betting.'1

ACKNOWLEDGMENTS

We are grateful to Bruce H. Garland, deputy director of the New Jersey Racing
Commission, Joseph J. Malan, director of mutuels at the Meadowlands Racetrack, and
Joe LaVista, New Jersey State auditor, for their help in providing the data, to the Sloan
Foundation and the National Science Foundation for financial support, and to two
referees for useful comments.

NOTES

1. The track take is the amount taken out of each bet by the racetrack to cover taxes, expenses
and profits, plus the amount ('breakage') resulting from rounding payoffs down to the nearest
10 or 20 cents.

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 1987] EFFICIENCY AND PROFITABILITY 297

2. The payoffs to these bets are more difficult to calculate. The general rule is: first, the original
bets of all successful place (or show) bettors are refunded; then the remaining portion of the
place (or show) betting pool (net of the track take) is divided equally between the two (in the
case of show bets, three) groups of individuals holding successful place (show) tickets. It
follows immediately that the reward to holders of a place ticket on horse i depends on which
other horse i also places. For the exact formulas, which also take breakage into account, see
Ziemba and Hausch (1984).
3. The takes are approximately 0-18 for win, place and show bets, and somewhat over 0-19 for
exactas at the Meadowlands Racetrack.
4. 'Probable payoff' numbers are usually displayed sequentially at certain locations. If the typical
race contains ten entrants, a bettor searching for market information about a two-horse exacta
must view and 'process' 90 possibilities.
5. If W, is the amount bet on horse i, the subjective probability that i will win is Wi/ W
the odds on horse i are defined as Di = W( - t)/ W-1, the subjective probability=
(1- t)/(1 + Di) and is monotone in Di. See Asch, Malkiel and Quandt (1982).
6. We observe in the tables below that rates of return to exacta combinations in various payoff
classes exhibit no systematic tendency. This is consistent with a failure of bettors to distinguish
between high- and low-probability combinations (see table). The prevalence of negative returns
raises the question of whether there are any 'strategies' that will yield positive profit in betting
on exactas. Using the logit model of Asch, Malkiel, Quandt (1984) to predict winners and
runners-up, and simulating various 'reasonable' betting strategies, indicates that on the average
profits are significantly negative.

Rates of Return on Exacta Bets: Constant Class Inverals

No. of pairs No. of winners Rate of

Payoff range in sample in category return

0-16 00 1896 162 -0-11

16-01-32-00 3653 110 -0 30
32-01-48-00 3139 68 -0-13
48-01-64-00 2676 38 -0-26
64-01-80-00 2317 34 0 05
80-01-96-00 1866 18 -0-13
96-01-112-00 1757 17 -0 04
112-01-128-00 1469 11 -0*24
128-01-144-00 1347 5 -0*54
144-01-160-00 1188 8 0*10
160-01-oo 19938 39 -0-46

7. It is interesting to note that this regression is reasonably similar to that obtained by Fabricand
(1965) on the basis of a completely different sample.
8. The simplest intuition for this is as follows: O0 is the probability that i wins; p /(1 -pi) is the
conditional probability that j wins in a race from which i is missing. If the two events are
independent, the product is the required probability.
9. The difference is significant at the 0 05 level. It is almost precisely accounted for by the fact
that daily double bettors pay a single track take of approximately 19 per cent, whereas parlay
bettors pay two takes of about 18 per cent. When the parlay payoffs are adjusted as if parlay
bettors paid a single 'daily double take' (multiply each Lk by 0-8091 and divide by 0.82032),
the mean Lk rises to $49 75, and is no longer significantly different from the mean Dk. It is
as if daily double bettors did not take into account that only one (slightly higher) take is
assessed against their bets.
10. We may also consider the issue of daily double profitability by predicting the winner of each
component of a daily double race pair on the basis of our logit model, and simulating a betting
strategy. The result of this simulation for 122 daily double pairs is an average rate of return
of -0-059, substantially better than the loss implied by the track take, but not profitable.
Overall, we find inefficiency and lack of profitability, as in the case of exacta betting; but we
do not confirm the 'smart money' hypothesis.
11. We have reported elsewhere (Asch, Malkiel and Quandt, 1982, 1984) some evidence suggesting
that 'smart money' may show up in the form of late betting in the 'win bet market'.

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 298 ECONOMICA [AUGUST

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