This exercise is a very simple version of a model of the bid-ask spread presented by Stoll
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This exercise is a very simple version of a model of the bid-ask spread presented by Stoll (1978). Consider an individual with constant absolute risk aversion α. Assume w˜ and x˜ are joint normally distributed with means μw and
μx, variances σ2 w and σ2 x , and correlation coefficient ρ.
(a) Compute the maximum amount the individual would pay to obtain w˜
when starting with x˜; that is, compute BID satisfying E[u(x˜)] = E[u(x˜ + ˜w−BID)].
(b) Compute the minimum amount the individual would require to accept the payoff − ˜w when starting with x˜; that is, compute ASK satisfying E[u(x˜)] = E[u(x˜ − ˜w +ASK)].
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