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Ask after a run of buys

Market makingHard

A contract is worth with probability and with 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 first orders were both buys. The market maker now sets the ask for the next order so that its expected profit, if it is a buy, is exactly zero. What is the ask? Give an exact fraction.

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A whole number, a decimal, a fraction like 3/8 or a percent.

Hint

Update the probability of after each buy, then apply the same step once more for the quote.

Solution
  1. A buy has probability when the value is and when it is . After the first buys the odds of are .
  2. Including the next buy, the probability of becomes .
  3. The ask is .

Answer: