RP1 Risk, return and CAPM price discovery

Three companies and a market index trade together. Prices are set by trading.

Objective

Build the portfolio that gives the best grade. The grade rises with the logarithm of final wealth, so a loss costs more than an equal gain pays.

What it shows

• Risk and return: what a stock pays for its risk against the market.
• Price discovery by a class: prices that nobody sets start wherever the first trades put them.
• The capital asset pricing model as the benchmark prices drift toward.

Watch out for

• Holding the stock with the highest expected return and ignoring how it moves with INDEX.
• A logarithmic grade, so the same gamble is worth less at high wealth than at low.
• Prices that start wherever the first trades put them and need time to settle.

Who takes part

• Investor — every student. Builds a portfolio from companies A, B and C. INDEX is the market. Short selling is allowed, and cash earns 1%.

Class size

Ten to forty students in one role. Four securities are priced by trading, so twenty or more gives each an active book.