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Is the flow toxic today
A market maker models each day's order flow as toxic or normal, a state it cannot see. A toxic day stays toxic the next day with probability . A normal day stays normal with probability . Last night's filter put toxic at . Heavy one-sided flow appears on of toxic days and of normal days, and it appears today. What is the updated probability that today is toxic? Give a fraction in lowest terms.
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Hint
Predict first with the transition table, then weight each state by the chance of today's flow.
Solution
- Predict: toxic today has probability , leaving for normal.
- Weight by the sighting: and .
- Normalise: .
Answer: