CA3 Convex incentives

Three stocks trade at one price. The two trader types are graded on curves of different shape.

Objective

Finish with a grade as high as possible. A convex grade pays more for a large gain than it costs for a large loss.

What it shows

• Incentives that change how much risk is worth taking.
• Two groups facing the same stocks and choosing different portfolios.
• How a pay curve, not a view, sets the risk a trader takes.

Watch out for

• Type 1 and type 4 making different choices from the same prices.
• A pay curve that is about final wealth and not about the price.
• Risking more than the class does and being right only by luck.

Who takes part

• Type 1 trader — three in four students. Graded on a convex curve of final wealth, with the smaller curvature.
• Type 4 trader — one in four. Graded on a convex curve of final wealth, with the larger curvature.

Class size

Twelve to forty students. Three in four are type 1, so with twelve there are three type 4 traders, enough for a comparison.