MAF759 Quantitative Methods For Finance

2009

QUANTITATIVE METHODS FOR FINANCE MAF 759

GROUP: 20 SUBMITTED BY: OMER JAVED 800606128 ZAHEER ABBAS 800267915

DATE: 7th MAY, 2009

INSTRUCTOR: RUIPENG LIU ABDUL HAYAT MUHAMMAD

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MAF759 Quantitative Methods For Finance

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QUESTION NO 1

PART A
From the given case it can be seen that Tony has made a down payment of $300,000 for a house that costs a total of $650,000, thus the remaining $300,000 he has borrowed so the mortgage monthly repayments for the next 30 years have been calculated with the mortgage formula as under: (Rosenthal, 2009).

M = P [ i(1 + i)n ] / [ (1 + i)n - 1]

The data available can now be used in this formula to calculate the desired monthly payments. DATA: Principal repayment amount=P= A$350,000 Loan Rate (per year) =I= 8% Monthly Loan rate=J= I/(12*100) = 0.0067/month Loan Term=L= 30 years Monthly Loan Term=N= 12*30= 360 months Monthly Repayments=M= ? MORTGAGE CALCULATION FORMULA: M = P* J 1 (1+J) ^ -N M= $350,000 * 0.0067 1-(1.0067) ^ -360 M= $350,000 * 0.0067 0.9094 Monthly Mortgage Repayments = $2568.18 (Excel reference: Question 1 sheet 1)

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PART B
CF0 CF1 CF2 CF3 CF4 CF5 CF6 CF7 CF8

($300,000) $50,000

$50,000

$50,000

$50,000

$50,000

$50,000

$50,000

$50,000

We will use Net Present Value (NPV) and the Internal Rate Of return (IRR) as two methods to calculate whether Tony should invest in the project or not.

Method 1: Net Present Value (NPV) Years 0 1 2 3 4 5 6 7 8 opportunity cost of capital NPV Method 2: Internal Rate Of Return (IRR) Years 0 1 2 3 4 5 6 7 8 IRR (Excel reference: Question 1 sheet 1) Cash Flows ($300,000) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 6.88% Cash Flows ($300,000) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 6.80% $892.86

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CONCLUSION: It can be seen here that the NPV is positive and IRR is 6.88% so both methods do not contradict and hence Tony would be benefited by investing in the project.

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QUESTION 2

PART A
The formula for continuously compounded growth is given has:

g = ln(FV/PV)
We have calculated the continuously compounded growth for the median sale price using this formula and the calculations are in the attached excel sheet. (Excel reference: Question 2 sheet 2)

PART B
Variables can be classified into two main categories: Quantitative variables. Categorical (Qualitative) variables.

Quantitative variables:
A variable that has meaningful arithmetic operations involved in it are categorized as Quantitative variables such as any type of yield, GPA, age or height of a person, different indexes or temperature or any other data that has numeric data in it.

Categorical variables:
A variable that does not involve any type of arithmetic operations is a categorical variable, they take one value out of many possible categories. Examples are different provinces, different types of colours, different universities attended or different courses of study. Now we will explain our variable according to the variable categories mentioned above and see in which class they fall (Variable Types).

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Suburb: Suburb falls in the categorical variable. As it doesnt have any numeric data involved in it, it only has names of different suburbs under consideration. Furthermore, as it doesnt have any order thus it can be sub categorized as nominal variable.

Postcode:
Postcode also falls under the categorical variable category as it doesnt contain meaningful numeric data.

Price 05,06:
Price for both 05 and 06 falls under the quantitative variable category as price is a meaningful numeric data which changes over time and is in a continuous process.

Growth:
Growth is also a quantitative variable as it is measures the change in the two prices on a continuous basis thus it contains meaningful numeric data in a continuous form.

PART C:

To obtain the levels of Melbourne house prices in 05 and 06 we have calculated the bins and frequencies (summery statistics) and then the Histogram in excel sheet attached. (Excel reference: Question 2 sheet 2)

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Summery Statistics is as follows:

PRICE 05

Intervals (184.00 x < 240.00) (240.00 x < 297.00)

Bin Range 240 297 353 410 466 523 579 636 692 749 806 862 919 975 1032 1088 1145 1201 1258 1315 1371 1428 1484 1541 1597 1654 1710 1767

Bin 240 297 353 410 466 523 579 636 692 749 806 862 919 975 1032 1088 1145 1201 1258 1315 1371 1428 1484 1541 1597 1654 1710 1767 1823 1880 More Total

Frequency 24 56 50 37 32 16 11 8 9 4 7 3 2 1 1 1 1 0 0 0 2 0 0 0 0 0 0 0 0 1 0 266

Rel. Frequency 0.09023 0.21053 0.18797 0.13910 0.12030 0.06015 0.04135 0.03008 0.03383 0.01504 0.02632 0.01128 0.00752 0.00376 0.00376 0.00376 0.00376 0.00000 0.00000 0.00000 0.00752 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00376 0.00000 1.00000

Cum. Frequency 0.09023 0.30075 0.48872 0.62782 0.74812 0.80827 0.84962 0.87970 0.91353 0.92857 0.95489 0.96617 0.97368 0.97744 0.98120 0.98496 0.98872 0.98872 0.98872 0.98872 0.99624 0.99624 0.99624 0.99624 0.99624 0.99624 0.99624 0.99624 0.99624 1.00000 1.00000

Cumulative % 9.02% 30.08% 48.87% 62.78% 74.81% 80.83% 84.96% 87.97% 91.35% 92.86% 95.49% 96.62% 97.37% 97.74% 98.12% 98.50% 98.87% 98.87% 98.87% 98.87% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 100.00% 100.00%

(1767.00 x < 1823.00) (1823.00 x < 1880.00)

1823 1880

(Excel reference: Question 2 sheet 2)

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PRICE 06

intervals (184.00 x < 240.00) (240.00 x < 297.00)

Bin Range 240 297 353 410 466 523 579 636 692 749 806 862 919 975 1032 1088 1145 1201 1258 1315 1371 1428 1484 1541 1597 1654 1710 1767

Bin 240 297 353 410 466 523 579 636 692 749 806 862 919 975 1032 1088 1145 1201 1258 1315 1371 1428 1484 1541 1597 1654 1710 1767 1823 1880 More Total

Frequency 21 51 42 40 33 21 8 13 5 6 5 5 6 2 2 0 0 2 2 1 0 0 0 0 0 0 0 0 0 0 1 265

Rel. Frequency 0.07925 0.19245 0.15849 0.15094 0.12453 0.07925 0.03019 0.04906 0.01887 0.02264 0.01887 0.01887 0.02264 0.00755 0.00755 0.00000 0.00000 0.00755 0.00755 0.00377 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00377 1.00000

Cum. Frequency 0.07925 0.19245 0.15849 0.15094 0.12453 0.07925 0.03019 0.04906 0.01887 0.02264 0.01887 0.01887 0.02264 0.00755 0.00755 0.00000 0.00000 0.00755 0.00755 0.00377 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00000 0.00377

Cumulative % 7.89% 27.07% 42.86% 57.89% 70.30% 78.20% 81.20% 86.09% 87.97% 90.23% 92.11% 93.98% 96.24% 96.99% 97.74% 97.74% 97.74% 98.50% 99.25% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 99.62% 100.00%

(1767.00 x < 1823.00) (1823.00 x < 1880.00)

1823 1880

(Excel reference: Question 2 sheet 2)

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Histograms for price 05 and price 06 are as follows:

PRICE 05

(Excel reference: Question 2 sheet 2)

PRICE 06

(Excel reference: Question 2 sheet 2)

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PART D
Suitability of mean, median mode for the price 05 and 06 have been calculated in excel attached sheet. PRICE 05 Mean 416 Median 356 Mode 220 (Excel reference: Question 2 sheet 2) PRICE 06 441 376 260

If we look at the mean, median and mode then we would most likely consider the median for both the prices to obtain the suitability as for a large number of data mean is usually not suitable whereas median is more suitable for a large data. Mode on the other hand in our data set is Bimodal which says that the set of data under consideration has two mode values. Thus in our data set to determine the suitability of the mean, median and mode for price 06 we can say that the median is more likely to be considered for price 06 rather than mode or mean.

PART E

(Excel reference: Question 2 sheet 2)

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Calculated variance and skewness for both price 05 and price 06 is as follows:

PRICE 05
Variance Standard Deviation Skewness 43287.743 208.057 2.698

PRICE 06
Variance Standard Deviation Skewness 53334.839 230.943 2.616

(Excel reference: Question 2 sheet 2)

ANALYSIS
The calculated data depicts that the variance which is the measure of volatility is higher for price 06 as compared to price 05, thus these price 06 could be more sensitive to changes than price 05. Moreover, if we look at the currency tables provided above then we can see that the price 05 frequency is more skewed as compared to price 06. Here we have to compare the scenes with the central location thus we can say that as the mean for both the prices is positive, the mean is greater than median.

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PART F
The variance for price 06 is greater than price 05 and we have also calculated the standard deviation mentioned in the above table to see the volatility of price changes and we can analyse that the variations in price 06 is more than the price 05 and thus the prices in 06 is more deviating from the mean as compared to price 05.

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MAF759 Quantitative Methods For Finance

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QUESTION NO: 3
PART A

The formula that we have used to calculate the continuous compounded daily return for the pre and post crises is as follows:

r = ln(FV/PV)
The calculated returns are in the attached excel sheet. (Excel reference: Question 3 "pre-crisis" sheet 3)

PART B: We have obtained the mean and standard deviation for both pre and post crisis which is as follows: Pre-Crisis: Mean = -0.147 Standard deviation is calculated at 1%, 2% and 3% respectively from the mean and it comes out to be as follows:
mean-1sd mean+1sd % of obs -1.68 1.38 74% mean-2sd mean+2sd % of obs -3.21 2.91 95% mean-3sd mean+3sd % of obs -4.74 4.44 99%

(Excel reference: Question 3 "pre-crisis" sheet 3)

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Post-Crisis: Mean = -0.101 Again for post-crisis the standard deviation is calculated at 1%, 2% and 3% respectively, from the mean and it comes out to be as follows:
mean-1sd mean+1sd % of obs 0.20 3.40 77% mean-2sd mean+2sd % of obs -1.40 5.00 95% mean-3sd mean+3sd % of obs -3.01 6.60 99%

(Excel reference: Question 3 "post-crisis" sheet 3)

PART C:

To determine whether the distribution of pre and post crisis has thicker tail than a normal distribution or not we have calculated the Excess Kurtosis which is as follows: Excel sheet reference (????? Pre-Crisis
Excess Kurtosis 2.290

(Excel reference: Question 3 "pre-crisis" sheet 3)

Post-Crisis
Excess Kurtosis 16.187

(Excel reference: Question 3 "post-crisis" sheet 3)

CONCLUSION:

For a normal distribution the excess kurtosis is zero where as in both pre and post crisis the excess kurtosis is greater than zero. Thus it can be depicted that the Tail for both pre and post crisis is Thicker than a normal distribution.

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PART D:

The probability of the negative returns in pre and post crisis has been calculated in the attached excel sheet. (Excel reference: Question 3 "pre-crisis", post-crisis" sheet 3) Pre-Crisis
Probability of Negative Return 0.544785

(Excel reference: Question 3 "pre-crisis" sheet 3)

Post-Crisis
Probability of Negative Return 0.568819

(Excel reference: Question 3 "post-crisis" sheet 3)

Analysis
From the probability of Negative returns obtained from both pre an post crisis it can be said that although the post crisis should have been worse than pre crisis as post crisis has better probability of getting good returns than pre crisis.

PART E:

Here we would consider different calculated data to state whether the daily returns for pre and post crisis is different and which is better as far as investment is concerned: DATA Pre-Crisis Probability of Negative Returns 0.544785 Excess Kurtosis 2.290 Skewness -0.214 (Excel reference: Question 3 "pre-crisis", post-crisis" sheet 3) Post-Crisis 0.568819 16.187 1.870

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Analysis
From the above data it is evident that for both the pre and post crisis the Excess Kurtosis is greater than zero so both have thicker tails than normal distribution and thus more peaked. However, post-crisis is far more Excess Kurtosis than pre-crisis which clearly depicts that postcrisis has more thicker and thus peaked tail than pre-crisis. Moreover, looking at the skewness of pre and post crisis it is seen that skewness for pre-crisis is negative which depicts that pre-crisis would not be beneficial for the investors as they would incur low returns Post-Crisis, on the other hand , has positive skewness which depicts that the investors would definitely be benefited from the returns.

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MAF759 Quantitative Methods For Finance

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QUESTION NO. 4

PART A:

OVERVIEW OF S&P 500 INDEX

The S&P Index has been working since 1957 in USA. It includes large publicly listed companies that invest hundreds of billions of Dollars in USAs two largest stock markets, the New York Stock Market and NASDAQ. Moreover, it is known as the best symbol of USA equities market with more than US$1.53 trillion in indexed assets and covers approximately 75% of USA equity market(Standard and Poors, 2009). S&P 500 is a very important element of USA economy that provides cost efficient investment portfolios. In addition, it is also a component of S&P global 1200. It is managed and maintained by the S&P index Committee, includes index analysts as well as the members of Standard and Poors economists, a division of McGraw-Hill. They follow the existed laws and police to maintain the index. The Committee is only responsible to select companies in the S&P 500 and it do not allow those who are not trading publicly or do not have sufficient liquidity. S&P 500 represents the market therefore those companies, are listed under and considered as the leading companies in particular industry.

OVERVIEW OF GENERAL ELECTRIC (G.E)

General Electric (G.E.) is a multinational company with diversified technology, media and financial services. It produces consumer appliances as well as financial services for their customers. In addition, it is the market leader in all its sectors, technological infrastructure, energy infrastructure, GE capital, NBC Universal and also one of the largest financial services providers in the world. Almost 25% of worlds total electricity is produce by GE power generation equipment and technology. In 2008, GE was the 12th largest company in the world with total revenue of $183 billion, has grown 13% as compare with 2003 (GE Annual Report, 2007) and 2nd largest by market capitalization. In other words it is a symbol of American business towards the world; they believe in to build strong leaders for its strategically implications. Moreover, GE is having the worlds most efficient business people in its management team from last 125 years that contributing to make it World Class Company as it is today. 17 | P a g e

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GE diversification gives strength to the company against any poor performance in its any business segment. It has approximately 36,000 technologists from the glob that working for the company to provide some superior solution for worlds toughest problems (General Electric, 2009). GE has affected by these financial crises, its earning has been decreased by 12% to 4.361 billion since 2008 from it continuous operating.

PART B

To calculate the required Time series graphs for both S&P 500 index and General Electric Co. (G.E) we have calculated the Returns and Return minus mean for both the indices to further calculate the average and standard deviation of the indices in the attached excel sheet. (Excel reference: Question 4 sheet 4)

Time Series Graphs constructed are as follows:

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S&P 500 Index and its Returns:

(Excel reference: Question 4 sheet 4)

General Electric (G.E) and its Return:

(Excel reference: Question 4 sheet 4)

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PART C:
To test whether the average return for both the indices is relatively different from the significance level of 1% and 5% we will conduct a z-test. As the sample here is too large (n=254) and the variance is unknown so for the z-test we would use sample standard deviation (s) instead of known population standard deviation ().

H0: = 0 versus HA: 0

Note that the rejection point Condition for the two-tailed test is as follows. At 5% Level: At 1% level If z > 2.57 Reject. If z < -2.57 Reject. if z >1.96 Reject. if z <-1.96 Reject.

The formula for the z-test is given as follows:

z=
(Excel reference: Question 4 sheet 4)

X 0 s/ n

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ANALYSIS
S&P 500 Index Z-Test (Excel reference: Question 4 sheet 4) General Electric Index:
Z-Test 1.6469938514

1.275778306

(Excel reference: Question 4 sheet 4) As from the z-test it can be seen that for S&P 500 index z=1.275778306 which satisfies the above condition and does fall within the range specified. Thus we would accept the null hypothesis at the 5% level and also at the 1% level of significance. Likewise, for our company G.E index z=1.6569938514, which is also within the range specified and thus the null hypothesis will be accepted at both 5% and 1% levels of significance.

PART D:
Too find the correlation between the two indices, the two different methods used here are correlation matrix and the covariance.

Method 1
First, we have used the correlation matrix from data analysis tool in excel to find the correlation between S&P 500 index and G.E index.

S&P 500 Index Return S&P 500 Index Return G.E Return (Excel reference: Question 4 sheet 4) 1 0.789580554

G.E Return 1

Thus the correlation matrix gives out the value as follows: Correlation 0.789580554

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Method 2
Now we will use covariance to find the correlation between S&P 500 index and G.E index by using the covariance formula provided in the excel sheet. Covariance (Excel reference: Question 4 sheet 4) 0.000724636

ANALYSIS
As the correlation coefficient is greater than zero hence it shows a positive linear relation between the two indices which means that if the A&P 500 index increases the G.E index would also increase and vice versa.

PART E
From the results in part D, we have the correlation between S&P 500 index and G.E index which is 0.789580554 thus to test whether we would accept the null hypothesis at 10% and 5% significance level we will use the "t-test". Here again the variance is unknown and the sample is too large (n=254). Note the conditions that: Critical value at 5% is 1.96 Critical value at 10% is 1.645

The formula given for t-test is as follows:

t=

r n2 1 r 2

t=

20.42575657

(Excel reference: Question 4 sheet 4) 22 | P a g e

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Analysis
The result from the t-test (t= 20.42575657) depicts that the critical value at 5% significance level is either greater than 1.96 or less than -1.96, thus at this level the null hypothesis will be rejected. Likewise, the critical value at 10% significance level is either greater than 1.645 or less than 1.645 so the null hypothesis is rejected at this level as well. Hence at both the levels there is no correlation between both S&P 500 index and G.E index and null hypothesis is rejected.

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References

1. GE Annual Report, 2007, Invest and Delivery Every Day, retrieved 5th May 2009, < http://www.ge.com/ar2007/pdf/ge_ar2007_full_book.pdf>

2. General Electrics, 2009, About Us, retrieve 6th May 2009, < http://www.ge.com/company/index.html> 3. Rosenthal, M, 2009, How to calculate mortgage payments, Foner Books, retrieved 6th May 2009, < http://www.fonerbooks.com/interest.htm>

4. Standard and Poors, 2009, S&P 500; Overview, retrieve 6th May 2009, <http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2, 0,0,0,0,0,2,1,0,0,0,0,0.html>

5.

Variable Types, retrieved 6th May 2009, <http://www.oswego.edu/~srp/stats/variable_types.htm>

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