Case Analysis: Program Trading

In Partial Fulfillment of the Requirements for the Subject Statistics 101

Submitted to: Mrs. Lynie Dimasuay Professor Laguna College

By: Karla Monica Limbo and Maria Aleni Verallo October 2012

Case Analysis: Program Trading:

Program trading is the name given to stock market buy-and-sell schemes carried out on a
computer. About a dozen major members of the New York Stock Exchange, and other companies, engage in this modern way of trading stocks. Usually, the computer programs are designed to follow a hedging strategy known as portfolio insurance or follow strategies of stock index arbitrage. The computer keeps track of the quoted prices of single securities as well as traded portfolios. Whenever the computer finds that price differences exist say, between the total quoted prices of a group of stocks and the price of a portfolio containing these stocks, the computer immediately issues an order to buy the cheaper form of the securities and to sell the equivalent, more expensive form of these securities. This is called

arbitrage. The computer thus aids in determining the existence of price differences and in
capitalizing these differences. Since the computer can act very quickly and handle large amounts of data, the result is trades of large quantities of stock in very short periods of time whenever a minute price difference is detected. It has recently been asserted that these sudden large trades result in unnaturally high volatility of stock market prices. This volatility is believed to be the source of many recent problems with the operation of the market. On January 15, 1988, the New York Stock Exchange began an experiment lasting six days aimed at determining whether or not program trading is indeed the culprit responsible for high price volatility. The Exchanged asked its members that engage in program trading to refrain from doing so over the six working days from January 15, 1988 through January 22, 1988.

The following table lists the daily changes in the Dow Jones Industrial Average for the period of January 5, 1988 through January 25, 1988

Date

Daily Change in Dow Jones Industrial Average +76.42 +16.25 +6.30 +14.09 -140.58 +33.82 -16.58 -3.82 -8.62 +39.96 +7.79 -27.52 -57.20 +0.17 +24.20

January 5, 1988 January 6, 1988 January 7, 1988 January 8, 1988 January 11, 1988 January 12, 1988 January 13, 1988 January 14, 1988 January 15, 1988 January 18, 1988 January 19, 1988 January 20, 1988 January 21, 1988 January 22, 1988 January 25, 1988

Separate the data into two groups. Make some necessary assumption and state them. Analyze the data and, based on your findings, make a recommendation to the New York Stock Exchange.

Solution:
With Program Trading(A) Daily Change Date

in Dow Jones Industrial Average

Without program trading(B)

Date January 15, 1988 January 18, 1988 January 19, 1988 January 20, 1988 January 21, 1988 January 22, 1988
Daily Change in Dow Jones Industrial Average

January 5, 1988 January 6, 1988 January 7, 1988 January 8, 1988 January 11, 1988 January 12, 1988 January 13, 1988 January 14, 1988 January 25, 1988

+76.42 +16.25 +6.30 +14.09 -140.58 +33.82 -16.58 -3.82 +24.20

-8.62 +39.96 +7.79 -27.52 -57.20 +0.17

T- TEST ON TWO INDEPENDENT SAMPLES:

Assumptions: 1. The observed positive and negative changes are random samples. 2. The random samples are independent before and after the event. 3. The population of positive and negative changes is normally distributed. PRELIMINARY TEST: Price volatility can be measured as the variance of prices. Test for equality of variance: 1. Ho: 21=22: Variance is equal.

Ha: 21>22: Variance of sample A is greater than the variance of sample B.

2. Test statistic: F test

F-Test Two-Sample for Variances Variable A 1.122222 3514.078 9 8 3.243456 4.81832 Variable B -7.57 1083.436 6 5

Mean Variance Observations df F F Critical one-tail

Solution:

F = [(max(s12,s22))/(min(s12,s22))]

F= 3514.0075/1083.436
F= 3.243456

3. Decision Rule: Reject Ho if Fc Ftab significance ().

(8,5)=

4.81832 at 0.05 level of

4. Decision: Since Fc=3.233456 <Ftab (8,5)= 4.81832, fail to reject Ho. 5. Conclusion: At 0.05, data provide evidence to say that variance of the samples is equal.

Test for equality of two population mean:

1. Ho: a=b; the mean daily changes in stock market prices with program trading and without program trading are equal. Ha: ba ; The mean daily changes in stock market prices with program trading is greater than the mean daily changes without the program trading. 2. Test Statistic: One tailed T- test: One tailed T-test: = 0.05: df= 9+6-2=13 Ttab=1.771

t-Test: Two-Sample with Equal Variances Variable A Variable B Mean 1.122222222 -7.57 Variance 3514.077519 1083.436 Observations 9 6 Pooled Variance 2579.215397 Hypothesized Mean Difference 0 df 13 t Stat 0.324741853 t Critical one-tail 1.770933396

3. Decision Rule: Reject Ho if Tc Ttab= 1.771, otherwise fail to reject Ho.

4. Decision: Fail to reject Ho since Tc= 0.32474 < Ttab 1.771. 5. Conclusion: At =0.05, we have evidence to say that the mean daily changes of stock market prices with program trading and without program trading are equal. Hence, there is no significant difference in

the changes in the stock market prices with or without the program trading.