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Break-even ask
A contract is worth or with equal probability. Each arriving trader is informed with probability , in which case the trader buys when the value is and sells when it is . Otherwise the trader is uninformed and buys or sells with probability each. The market maker sets the ask so that the expected profit on a buy order is exactly zero. What is the ask?
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Hint
The ask equals the expected value given that the order is a buy.
Solution
- A buy arrives with probability when the value is , and with probability when it is .
- By Bayes, the probability that the value is given a buy is .
- The ask is .
Answer: