Financial Economics

Qualified Writers
Rated 4.9/5 based on 2480 reviews

100% Plagiarism Free & Custom Written - Tailored to Your Instructions

Introduction:

The stock I choose is AT&T, INC.to generate this optimal portfolio construction. AT&T Inc. is an American multinational telecommunications corporation, headquartered at Whitacre Tower in downtown Dallas, Texas. AT&T is the second largest provider of mobile telephone and the largest provider of fixed telephone in the United States, and also provides broadband subscription television services.

Outline:

A.Choose one stock that has been traded for more than 15 years and analyze it. (AT&T, INC)

Provide a graph of the yearly stock return over time.

Provide a table of summary statistics on returns.

B.Choose reasonable values for the parameters u and d.

Convert the annual returns that we got from excel into continuously compounded annual returns.

Find the sample standard deviation of the continuously compounded annual returns.

Use the number of periods (12) and the sample standard deviation to adjust u and d.

C.Forecast the future possible prices of the stock.

Let Sbe the price of the stock and build a 12-period tree for the price of the stock where u and d are used to forecast the future stock’s price.

D.Use the binomial model to price a call option on the stock.

Build a tree that has the option price at the origin vertex and at the end vertices.

Find the returns to one-month T-Bills for each month in the past 10 years and use this to estimate the risk-free interest rate.

E.Find the actual price of the call option with exercise price.

Compare the actual price to the price I computed.

ECON

4751

project 2 3

Summarize what I learned from the experiment.

Data section:

A. Choose one publicly traded stock.

The stock I choose is AT&T, INC.

Before I use the binomial model, I need a way to choose reasonable values for the parameters u and d. So that I need to get some basic statistics of this stock. I got the historical price data from the first trading day of December through 1996-2015, which contains the last 20 years. And then I use these data through EXCEL to calculate the yearly stock return.

To calculate the yearly stock return, I use the formula

( ℎ

 

 

 

 

ℎ − ℎ

 

 

 

 

 

 

 

 

ℎ)

 

 

 

ℎ ℎ

For example, to get the yearly stock return of 2015-12-1, I use the adjusted close price in 201512-1 minus the adjusted close price in 2014-12-1, and then divided by the adjusted close price in 2014-12-1. Then I just use the EXCEL automatically to get other years’ yearly return. The table below shows the historical price data from 2015 to 1996 and the calculated yearly return.

Date

Open

High

Low

Close

Volume

Adj Close

yearly return

 

 

 

 

 

 

 

 

12/1/15

33.779999

33.970001

33.580002

33.77

33523000

32.893505

0.063051326

 

 

 

 

 

 

 

 

12/1/14

35.279999

35.369999

32.07

33.59

27279700

30.942537

0.006594704

 

 

 

 

 

 

 

 

12/2/13

35.18

35.299999

33.599998

35.16

21568400

30.739817

0.097220959

 

 

 

 

 

 

 

 

12/3/12

34.23

34.689999

33.099998

33.709999

25837000

28.016068

0.174876869

 

 

 

 

 

 

 

 

12/1/11

28.93

30.299999

28.51

30.24

24893900

23.845961

0.090239279

 

 

 

 

 

 

 

 

12/1/10

28.120001

29.559999

28.030001

29.379999

21588700

21.872227

0.116025153

 

 

 

 

 

 

 

 

ECON

 

 

 

 

 

 

4751

 

 

 

 

 

 

 

project

 

 

 

 

 

 

 

2

 

 

 

 

 

 

 

4

 

 

 

 

 

 

 

 

12/1/09

27.18

28.610001

26.940001

28.030001

23437800

19.598328

0.046777088

 

 

 

 

 

 

 

 

12/1/08

28

30.65

26.57

28.5

34290000

18.722542

-0.280535526

 

 

 

 

 

 

 

 

12/3/07

38.490002

42.790001

37.709999

41.560001

26775800

26.022886

0.20608776

 

 

 

 

 

 

 

 

12/1/06

33.950001

36.209999

33.740002

35.75

25337800

21.576279

0.531621767

 

 

 

 

 

 

 

 

12/1/05

25.15

25.6

24.280001

24.49

12611400

14.087211

0.002336996

 

 

 

 

 

 

 

 

12/1/04

25.4

26.559999

24.950001

25.77

8332400

14.054366

0.037790113

 

 

 

 

 

 

 

 

12/1/03

23.299999

26.15

22.950001

26.07

9426900

13.54259

0.016794701

 

 

 

 

 

 

 

 

12/2/02

28.75

29.1

24.85

27.110001

7028100

13.318903

-0.283115434

 

 

 

 

 

 

 

 

12/3/01

37.599998

40.290001

37.200001

39.169998

7303400

18.578867

-0.160866127

 

 

 

 

 

 

 

 

12/1/00

54.6875

55

42.625

47.75

8059400

22.140528

0.000705901

 

 

 

 

 

 

 

 

12/1/99

52.0625

55.5

47.375

48.75

4802700

22.12491

-0.07382148

 

 

 

 

 

 

 

 

12/1/98

48.25

54.875

47.25

53.625

2307600

23.888386

0.497099417

 

 

 

 

 

 

 

 

12/1/97

73

76.125

69.5625

73.25

2673000

15.956446

0.455790318

 

 

 

 

 

 

 

 

12/2/96

52.375

55.25

48.5

51.875

1865400

10.960676

-0.06327295

 

 

 

 

 

 

 

 

http://finance.yahoo.com/q/hp?s=T&a=11&b=1&c=1995&d=11&e=1&f=2015&g=m

After finishing calculating the yearly stock return, I generate a graph of the yearly stock return of AT&T stock over time. From this graph, we can see the fluctuation of the yearly stock return clearly.

ECON

4751

project 2 5

In addition to the graph, I would like to provide a table of summary statistics on returns, including the mean, variance, skewness, kurtosis, median, interquartile range, and maximum and minimum values.

 

SUMMARY OF STATISTICS

 

 

 

Mean

 

0.074070042

 

 

 

Variance

 

0.049156136

 

 

 

Skewness

 

0.645230162

 

 

 

Kurtosis

 

0.453572607

 

 

 

Median

 

0.0422836

 

 

 

Interquartile range

 

0.5320568

 

 

 

Maximum values

 

0.531621767

 

 

 

Minimum values

 

-0.283115434

 

 

 

ECON

4751

project 2 6

B. Choose reasonable values for the parameters u and d.

• Convert the annual returns into continuously compounded annual returns.

I use the formula (textbook, page 162): Continuously compounded rate of return rcc= In (1+effective annual rate)

As we all known, the relationship between APR (annual percentage rate of return) and EAR (effective annual rate of return) is: 1+EAR= (1+T*APR)1/T. If we fix APR and increase the frequency of compounding (make T very small and approaches to zero), (1+EAR) will converge to e APR. If we fix EAR and increase the frequency of compounding (make T very small and approaches to zero), (APR) will converge to In(1+EAR). This is called Continuously compounded rate of return.

Below is the table showing the continuously compounded rate of return. Use the formula Rcc=ln(1+EAR)

 

Find the sample standard deviation of the continuously compounded annual returns. After we calculating the continuously compounded annual returns, we can get the variance of returns is σ2=0.04152903, and the standard deviation of the returns is σ

=0.2037867268. This is the unbiased estimate of the standard deviation of the continuously compounded annual returns.

Use the number of periods together with σ to adjust u and d.

The binomial model we will use for this project is a 12-period model. T=12. Then we calculate the parameters u and d. The up and down factors are calculated using underlying volatility, σ, and the time duration of the step, which is t=1/12. (measured in years). From the condition that the variance of the log of the price is σ2t, we have:

u=exp(σ ∆ ) d=exp(-σ

∆  so that,

ECON

4751

 

project

 

2

 

8

u= 1.060592974

Use as u=1.06 d=0.9428687767

Use as d=0.94

 

C. Forecast the future possible price of the stock.

Build a 12-period tree for the price of the stock (Let Sbe the price of the stock on Dec1- 15).

From the original historical data of the AT&T stock, we can see that the price on Dec-1-15 was $32.893505, so we set S0=$32.893505 ≈ $32.89. Then I use S0=$32.89, u=1.06, d=0.94 to build a 12 period tree for the price of the stock to forecast the price on Jan-1-16, Feb-1-16, etc. up to Dec-1-16.

Assume a stock price can take two possible values: The stock will either go up and down. Call the factor by which it goes up u, and factor by which it goes down d.

In this case, we set the AT&T stock price on Dec-1-15 as S0=$32.89, the stock price will either increase by the factor of u=1.06 to $34.8634 (=$32.89*1.06) or fall by a factor of d=0.94 to $30.9166(=$32.89*0.94). In the next period, there would be four possibilities. When the price was already increased to $34.8634, it would either increase by the factor of u=1.06 to $39.075204(=$36.8634*1.06) or decrease by a factor of d=0.94 to $32.771596(=$34.8634*0.94). On the other hand, when the price was already fall to $30.9166. it would still either increase by the factor of u=1.06 to $32.117596 and decrease by the factor of d=0.94 to $29.061604. This is always the case that with the time changing, the stock price would either increase by a factor of u and decrease by a factor of d.

So that we can build a 12-period tree for the price of the AT&T stock in EXCEL.

D. Use the binomial model to price a call option on the stock.

Estimate the risk-free interest rate.

In order to use the binomial model, I need a risk-free interest rate. So we are going to find the returns to one-month T-Bills for each month in the past 10 years and estimate the

ECON

4751

project 2 9

average monthly return of T-Bills. Using this estimate as our risk-free rate for each

month. Below is the table showing the historical data.

The original data below is from https://research.stlouisfed.org/fred2/series/TB4WK/downloaddataUNIT: PERCENT

Then I use the data above from historical data of one-month T-Bills for each month in the past ten years to estimate the average monthly return. (UNIT: PERCENT)

So the average monthly risk free return we estimated is R=1.3565 %

ECON

4751

project 2 10

Build a tree that has the option price (C) at the origin vertex and at the end vertices. After we have already built a 12-period tree for the price of the AT&T stock, we can use those data to build a tree that has C, the option price at the origin vertex and at the end vertices. Replace the notation for the end vertices with the option payoff given the price forecast on DEC-1-16.

Before we are going to build the tree, the parameters we have known is shown in the table below.

ECON

4751

project 2 11

Then we need to use these parameters to calculate the payoff of the call, build tree like below:

 

 

 

Cu12

 

Cu4

 

Cu11d

 

Cu3

 

Cu10d2

 

Cu3d

 

Cu9d3

 

Cuu

 

 

 

Cu8d4

 

2

…….

 

Cu d

 

Cu

2 2

 

Cu7d5

Cu d

 

C

Cud= Cdu

 

Cu6d6

Cd

Cud2

 

 

Cdd

 

Cu5d7

 

Cud3

 

Cu4d8

 

Cd3

 

Cu3d9

 

Cd4

 

 

 

 

Cu2d10

Cu1d11

 

 

 

Cd12

 

 

 

Cu=uS0-X

Cd=dS0-X

At each final node of the tree — i.e. at expiration of the option — the option value is simply its intrinsic, or exercise, value.

Max

[ (), 0 ], for a call option

 

Max

[ ( –

), 0 ], for a put

 

option:

 

 

 

Where is the strike price and

is the spot price of the underlying asset at the

period. So

in the period 12, I just use the stock price I calculated minus the exercise price, compared with zero, the bigger one is what we want for the payoff of the call in period 12.

Then we are going to calculate the payoff in the period 11.

We can generate The Hedge Ratio for other two-state problems:

ECON

4751

project 2 12

Cu=uS0-X

Cd=dS0-X (X is the exercise price)

This ratio allows us to come up with a simple algorithm to follow when pricing call option.

The first H in the period 11 =

 

6789:6788; , which means (the highest payoff in period

12– the 789

lower payoff in period 12) divided by (the highest stock price in period 12 – the lower stock price in period 12). This ratio represents that the portfolio is composed of H shares and one call

written. So the payoff will be H*U12S– C12. And then we need to find the present value of this

portfolio using the risk free risk we estimated. So to get this portfolio today, we need to pay

(H*U12S– C12)/(1+r) before. Hence (H*U12S– C12)/(1+r) = H*U11S– Cu11and then we can

get the payoff Cu11.

If we rearranging the equation H, and plugging this into (H*U12S– C12)/(1+r) = H*U11S– Cu11

We can find that at last Cu11=((Cu12-Cu11d)/(u-d)) – ((d*Cu12-u*Cu11d)/((u-d)*(1+r))). So we can set the general payoff like this. Then I use EXCEL to do the rest part. The table below is the option price tree for all 12 periods.

ECON

4751

project 2 13

So the call price Icalculated at lastis $7.68488.

E. Comparison & Summary

• Compare the actual price with the price I calculated.

The option price we calculated is for 2016, so I went to the Yahoo Finance to get the option price close to the end of the 2016.The cloestprice is on January-20-2017 and the price is $7.00. 

As we can see from the option price tree, the call price I calculated is $7.68488, which is very similar to the actual price.

Price: £79

100% Plagiarism Free & Custom Written - Tailored to Your Instructions