Where is fair value in a two-way market?

Question

A stock shows 50.40 bid / 50.60 ask, with 500 shares resting on each side. Nobody is willing to buy above 50.40 or sell below 50.60 right now. What is your best single estimate of fair value, and what is the spread?

Accepted Answer

With equal size on both sides and no other information, your best point estimate of fair value is the midpoint: 	ext{mid} = \frac{50.40 + 50.60}{2} = 50.50. The spread is the distance between the two quotes: 	ext{spread} = 50.60 - 50.40 = 0.20 \;(	ext{20 cents}), and the half-spread, the distance from mid to either quote, is 10 cents. Why the mid? The bid is the most anyone will pay and the ask is the least anyone will accept. The true value sits somewhere in that no-trade zone, and with balanced size the symmetric guess is the center. Two caveats interviewers like to add: - If the sizes w…

Where is fair value in a two-way market?

Your answer

More Market Making questions