Mathematics for Economics and Finance

January 2016 Exam Solution

Instructor: Mikica Drenovak

Instructions:

• Exam paper is provided by the proctors. Fill in the required information on every
sheet. No own paper is allowed. You must turn in all sheets at the end of the exam,
including any scratch paper. All exam questions must be returned.

• The exam includes 4 questions. Tell the proctor immediately if something is missing.
Start your answers to every question at the top of a new page.

• The duration of the exam is 180 minutes. If you arrive late for the exam, you must
finish with all other students. No extension can be granted.

• This is a closed-book exam. You are allowed to use a black or blue ink pen, a
non-programmable calculator, and a dictionary only. The pen must not write
red or green. No pencils are allowed. The dictionary may not have any markings.
You are allowed no other material, including cell phones, computers, class material,
books, cheat sheets.

• Show all derivations and computations. Numerical results without corresponding

analytical derivations receive no points. The solution approach has to be clear to the
grader. Write legibly.

• The total number of points is 100.

1
Question I (25 points)
1. Are the following statements true or false? Answers without justification receive no
points.

(a) The eigenvalues of the 3×3 identity matrix are λ1 = λ2 = λ3 = 1.

(b) A 3×4 matrix with rank 2 has 3 linearly independent vectors.
(c) If the 3 eigenvalues of a 3×3 matrix A are { 34 ; 54 ; 56 }, then the determinant of
(A4 )−1 = 16.
(d) If the column vectors of an orthogonal matrix have length equal to 1, then the
scalar product of any two of them is equal to 1.
√
(e) The function f (R) → R, f (x) = x2 + 3x + 21 is bijective.
(f) Cov(aX + b, dY + e) = adCov(X, Y ), where X and Y are random variables and
a, b, d, e are constants.
(g) The Gaussian distribution is characterized by the first four moments.
(h) A concave function is never strictly quasi-concave.

2. Are the following statements true or false? Answers without justification receive no
points.
x2 x3 x4
(a) The Taylor series around the point a = 0 of cos(x) is 1 + 2!
+ 3!
+ 4!
+ ...
n
(b) lim (1 + nx ) = exp(x)
x
n→∞
d
Ry
(c) dy 0
ln(xy)dx = 2ln(y) + 1

3. (a) A random variable X has the pdf:


1/4 , 0 ≤ x ≤ 1

f (x) = 3/4 , 1 < x ≤ 2

0 , otherwise


Compute the probability P(x ≤ 43 ).

(b) Consider the function
1 2
f (x) = ae− 2 x ,
where x ∈ R+ and a is a constant. What is the value of a if f (x) is a probability
density function? Justify your answer.

2
Question I Solution:

1. (a) TRUE, Eigenvalues of triangular matrix are equal to the values of principal diag-
onal.
(b) FALSE, Rank of matrix corresponds to the number of linearly independent vec-
tors.
(c) TRUE, The determinant of matrix is equal to product of eigenvalues. If eigenval-
−1
ues of A are λ1 , λ2 and λ3 then eigenvalues of A4 are λ−4 −4 −4
1 , λ2 and λ3 ⇒ the
determinant = ( 43 53 65 )4 = 24 = 16.
(d) FALSE, the column vectors of an orthogonal matrix are orthonormal ⇒< ai , aj >=
0 for i 6= j.
√
(e) FALSE, y = x2 √ + 3x + 21 is parabola with√ the minimum at vertex with coordi-
nates (− 23 , 94 + 21). For any y > − 49 + 21 there exist two different values x1
and x2 such that f (x1 ) = f (x2 ) = y, therefore the function is not injective.
(f) TRUE, E[(aX + b − E[aX + b])(dY + e − E[dY + e])] = adE[XY ] − adE[X]E[Y ] =
adCov(X, Y ).
(g) FALSE, The Gaussian distribution is characterized by the first two moments.
(h) FALSE, e.g. a strictly concave function is both concave and strictly quasi-concave.
x2 x4
2. (a) FALSE, The Maclaurin series expansion is 1 − 2!
+ 4!
− ....
(b) FALSE, We know that limn→∞ (1 + n1 )n = e
n
So, limn→∞ (1 + nx ) x = limt→∞ (1 + 1t )t = e with t = nx ,
Ry Ry
(c) TRUE, dyd
0
ln(xy)dx = 0 xdx xy
+ ln(y 2 ) = xy |x=y
x=0 +2ln(y) = 1 + 2ln(y).

3. (a) P(X ≤ 34 ) = 34 41 = 16
3
= 18.75%
∞ √
1 2
(b) ae− 2 x dx = a 22π ⇒ a = √22π
R
0

3
Question II (25 points)
A solution planner is faced with the following optimization problem:

max f (x, y, z) = 2x + y + az,

(x,y,z)∈D

where
D = {(x, y, z) ∈ R3 | x2 + ay 2 ≤ a, x2 + az 2 ≤ a, a > 0}.

1. Explain why f must have a maximum on D.

2. For which points (x, y, z) and parameter a does constraint qualification hold?

3. Formulate the necessary conditions for the maxima of f on D.

4. Find the optimum.

5. What is the value of a if the value of z at optimum is √1 .

2

6. Without computations, what can you say about the solution of the optimization prob-
lem if:

(a) D = {(x, y, z) ∈ R3 | x2 + ay 2 ≥ a, x2 + az 2 ≤ a, a > 0}.

(b) You minimize f (x, y, z).

4
Question II Solution:

1. The objective function f (x, y, z) is continuous, and the constraint set D is closed and
bounded. Therefore by Weierstrass’ Theorem we can conclude that f (x, y, z) has a
maximum on D.

2. There are two constraint functions:

g1 (x, y, z) = a(1 − y 2 ) − x2 ≥ 0, g2 (x, y, z) = a(1 − z 2 ) − x2 ≥ 0,

The constraints are not linear.

The gradients are:

5g1 (x, y, z) = (−2x, −2ay, 0) and 5 g2 (x, y, z) = (−2x, 0, −2az) ,

The rank of the Jacobian, rank([5g1 ; 5g2 ]) can be lower than 2 if:

(a) a = 0, impossible because by definition a > 0

(b) y = z = 0, then two cases can happen
i. x = 0, the rank of the Jacobian is 0, but the constraints cannot be binding
with a > 0. Therefore the rank of the Jacobian is equal to the maximum
number of binding constraints and constraint qualification is satisfied.
ii. x 6= 0, the rank of the Jacobian is 1, but both constraints become identical
(x2 ≤ a). With only one constraint the maximum number of binding con-
straints is 1 and equal to the rank of the Jacobian in this case too. Therefore
the constraint qualification is satisfied.
It implies that CQ is satisfied for any point of the set D.

3. The Lagrangian is given by L = 2x + y + az + λ1 (a(1 − y 2 ) − x2 ) + λ2 (a(1 − z 2 ) − x2 )

The necessary first-order conditions are:
∂L
1: ∂x
= 2 − 2λ1 x − 2λ2 x = 0,
∂L
2: ∂y
= 1 − 2λ1 ay = 0,
∂L
3: ∂z
= a − 2λ2 az = 0,

The necessary slackness conditions are:

λ1 ≥ 0, a(1 − y 2 ) − x2 ≥ 0, λ1 (a(1 − y 2 ) − x2 ) = 0,
λ2 ≥ 0, a(1 − z 2 ) − x2 ≥ 0, λ2 (a(1 − z 2 ) − x2 ) = 0.

4. from 1: x∗ = 1
λ1 +λ2
from 2: y ∗ = 1
2aλ1
⇒ λ1 6= 0 ⇒ a(1 − y 2 ) − x2 = 0
from 3: z ∗ = 1
2λ2
⇒ λ2 6= 0 ⇒ a(1 − z 2 ) − x2 = 0

i.e. both constraints must be binding at optimum.

With both constraints binding we find y ∗ = ±z ∗ .

5
 From first order conditions and slackness conditions y and z must be positive therefore
we find y ∗ = z ∗ .
Then from 2 and 3: 2aλ1
1
= 2λ1 2 ⇒ λ1 = λa2 .
Back in 1 we find: x∗ = λ2 (a+1)
a

Using 3 and slackness conditions we find:

1 4aλ22 − a a2
x2 = a(1 − z 2 ) = a(1 − ) ⇒ = ,
4λ22 4λ22 λ22 (a + 1)2
4a2
⇒ 4aλ22 − a = ,
(a + 1)2
1 a
⇒ λ22 = + ,
4 (a + 1)2
s
1 a
⇒ λ∗2 = + ,
4 (a + 1)2

q
1
4
+ a 2
(a+1)
Then we find λ1 = a
and:

1 a
x∗ = q ,
1
+ a a+1
4 (a+1)2
1
y∗ = z∗ = q .
a
2 14 + (a+1)2

5. Using previous result q 1 = z ∗ therefore with z ∗ = √

1
we find a = 1.
2 14 + a 1
2
(a+1)2 2

6. (a) The domain D is no more bounded. In this case y becomes free and there is no
more optimum.
(b) The domain D is bounded and by Weierstrass we can find an optimum.

6
Question III (25 points)
You are portfolio manager for the glamorous hedge fund M IKIP ERF . You are the only
one in the fund to generate positive alpha returns since your arrival five years ago, and it
appears you are the only one who knows how to use quantitative techniques.
You are about to implement a new strategy in which you experiment with a combination
of three asset classes. Asset classes 1, 2, and 3 generate random returns with holding period
expected returns µ1 , µ2 and µ3 , respectively. The maximum amount you can invest is W .
Before investing you want to analyze the properties of the portfolio variance. The portfo-
lio variance is the function V (w1 , w2 , w3 , A), where w1 , w2 , and w3 are the portfolio weights
for each asset class and A is the covariance matrix of asset class returns given by
 
3 C 0
A= C 3 0 
0 0 3
1. (a) If you assume that you invest W , what is w1 + w2 + w3 ?
(b) If you assume that you invest the percentages w1 , w2 and w3 in each asset class,
what is the expected return of the portfolio for the holding period?
(c) If you assume that you invest W , what is the expected increase/decrease of W
for the holding period?
2. (a) Is A symmetric?
(b) Is the matrix I − A(A0 A)−1 A0 idempotent, with I the rank 3 identity matrix?
3. Suppose you want to minimize the portfolio variance V and you are allowed to invest
in only one asset class:
(a) Which asset do you choose (that is, what are the optimal portfolio weights w1 ,
w2 , and w3 )?
(b) What is the portfolio variance in this case?
4. Suppose that the eigenvalues of the matrix A are 1, 3 and 5. What are the values of C?

For the next questions assume that:

The eigenvalues of A are 1, 3 and 5, and C=2.
5. Find the eigenvectors corresponding to the eigenvalues of A.
6. Compute A−1 and explain what is the spectral decomposition of A.
7. Determine the definiteness of the covariance matrix A.
A−1 1
8. The minimum variance portfolio M V is 10 A−1 1
, where 1 is equal to (1, 1, 1)0
(a) Find the weights that permit to minimize the variance of the portfolio i.e. compute
MV .
(b) What is the variance of the portfolio now? Compare your answer with your
solution in 3 and explain the difference.

7
Question III Solution:

1. w1 + w2 + w3 = 1

The expected portfolio return is:

(w1 , w2 , w3 )(µ1 , µ2 , µ3 )0 = w1 µ1 + w2 µ2 + w3 µ3 .

The expected wealth increase/decrease is:

W (w1 µ1 + w2 µ2 + w3 µ3 ).

2. A is symmetric as A0 = A.
I − A(A0 A)−1 A0 is idempotent as:
I − A(A0 A)−1 A0 = I − AA−1 A0−1 A0 = I − II = I − I = 0.
Students may also compute (I − A(A0 A)−1 A0 )(I − A(A0 A)−1 A0 ):
(I−A(A0 A)−1 A0 )(I−A(A0 A)−1 A0 ) = I−A(A0 A)−1 A0 −A(A0 A)−1 A0 +A(A0 A)−1 A0 A(A0 A)−1 A0 =
I − 2A(A0 A)−1 A0 + AI(A0 A)−1 A0 = I − A(A0 A)−1 A0
All the steps of the proof are required.

3. Without diversification, you invest only in the asset with the lowest variance and so here
all assets are equivalents, the solutions are (1, 0, 0), (0, 1, 0) or (0, 0, 1). The portfolio
variance is 3.
 
3−λ C 0
4. det(A − λI) = det  C 3−λ 0 =
0 0 3−λ
= (3 − λ)[(3 − λ)2 − C 2 ]
If we know that one eigenvalue is 3 then (3 − λ)2 − C 2 = 0,
λ2 − 6λ + 9 − C 2 = 0. Then using the solutions proposed:

λ2 − 6λ + 9 − C 2 = (λ − 1)(λ − 5) = λ2 − 6λ + 5
⇒ C = ±2

5. The corresponding eigenvectors matrix G is the following:

√ √
−√ 22 0 2
 
√2 √
2
 2 0
2 2
2 ,
2
' 0.7071.
0 1 0
3
− 25 0
 
5
6. Using previous result: A−1 =  − 25 53 0 .
0 0 13
Students do not need to find the inverse of A by spectral decomposition, but they must
explain how spectral decomposition may be used: By definition 2.22, p.62, A = GΛG0
and A−1 = GΛ−1 G0 .

8
7. The variance of the portfolio V = (w1 , w2 , w3 )A(w1 , w2 , w3 )0 . We can compute the
leading principal minors of A.
D1 = 3 > 0,
D2 = 5 > 0,
D3 = 3D2 = 15 > 0.
So we can conclude that the matrix is positive definite (proposition 2.15 p.49).
Remark: because the eigenvalues are positive, it permits also to conclude that the
quadratic form is positive definite.

A−1 1
8. The covariance matrix A is positive definite then we must find x: x = 10 A−1 1
, where 1
is equal to (1, 1, 1)0 :

3 3 5 3 5 3 3 5 3 3 5 0
The solution is ( 11 , 11 , 11 ), 11 ' 0.27 and 11 ' 0.45 the variance of M V = ( 11 , 11 , 11 )A( 11 , 11 , 11 ) =
15
11
' 1.36. The variance is significantly below the variance found in question 3 thanks
to diversification.

9
Question IV (25 points)
1. Suppose that we draw a random sample X1 , X2 , ..., Xn of n i.i.d. observations from
a Normal(µ, σ 2 ) distribution. Show that the Maximum Likelihood Estimators M LEs
for the parameters µ and σ are:
n
xi
P
(a) µ̂M LE = n
=x
i=1
n
2
P (xi −x)2
(b) σ̂M LE = n
i=1

2 0
2. The asymptotic distribution of θ̂M LE = (µ̂M LE , σ̂M LE ) is joint Normal, with variance
−1
I(θ) where I(θ) is the Fisher information matrix. Find:
2
(a) The asymptotic distribution of µ̂M LE and σ̂M LE
" ∂ 2 ln(f (X|θ)) ∂ 2 ln(f (X|θ)) #
∂µ2 ∂µ∂σ 2
(b) I(θ)−1 , knowing that I(θ) = −E ∂ 2 ln(f (X|θ)) ∂ 2 ln(f (X|θ)) ,
∂σ 2 ∂µ ∂(σ 2 )2
where f (X | θ) is the likelihood function.

3. A discrete random variable X is said to have a Poisson distribution with parameter

λ > 0, if, for k = 0, 1, 2, ..., the probability mass function f of X is given by:

λk e−λ
f (k, λ) = P(X = k) = k!

(a) Compute the Moment Generating Function MGF of the Poisson distribution
Hint: use Taylor series for ex

4. Two ships, Aurora and Unicorn, will arrive in the port independently within the next
24 hours. Every moment of the arrival of each ship is equally possible. Only one ship
can be unloaded at the time. The time needed to unload Aurora and Unicorn is 1
hour and 2 hours, respectively.

(a) Find the probability that the ship which arrives last will have to wait

Hint: If we denote arrival time of Aurora and Unicorn with respectively x and y, then
the following holds:

• 0 ≤ x, y ≤ 24
• Favorable outcomes for calculating stated probability are those which satisfy:
x≤y ≤x+1

You may find missing inequality/ies for favorable outcomes and use graphical repre-
sentation to solve the problem.

10
Question IV Solution:

(x −µ)2
√ 1 exp(− i 2 )
1. f (xi | µ, σ 2 ) =2πσ 2 2σ
2 n √ 1 (xi −µ)2
L(µ, σ ) = Πi=1 2πσ2 exp(− 2σ2 )
−µ)2
ln(L) = − n2 ln(2σ) − n2 ln(σ 2 ) − ni=1 (xi2σ
P
2

Then FOCs are:

∂ln(L) 1
Pn
∂µ
= σ2 i=1 (xi − µ) = 0
∂ln(L) n 1
Pn
∂σ 2
= − 2σP 2 + 2σ 4 i=1 (xi − µ)2 = 0
⇒ µ̂M LE = Pni=1 xni = x
n
(x −x)2
⇒ σˆ2 M LE = i=1 n i

2. We want to compute the Fisher information matrix:

2
−E[ ∂ ln(f ∂θ∂θ0
(X|θ)
], where f is the likelihood function for θ. Then computing the first order
derivatives we Pnget:xi −µ Pn xi −µ 2
[ ∂ln ,
∂µ ∂σ 2
∂ln
] = [ n
i=1 σ 2 , − 2σ 2 + 2
1
i=1 ( σ 2 ) ]
Computing the second order derivatives :
∂ 2 ln
∂µ2
= −n σ2
∂ 2 ln
= 2σn4 − ni=1 ( xiσ−µ 2
P
∂(σ 2 )2 3 )
∂ 2 ln ∂ 2 ln
= ni=1 xiσ−µ
P
∂µ∂σ
= ∂σ∂µ 4 After simple algebra and computing the expectation we find:
 σ2 
∂ 2 ln(f (X|θ) −1 0
−E[ ∂θ∂θ0 ] = n
4 , Therefore:
0 2σn
   σ2 
a µ 0
θ̂ → N( , n
4 )
σ 0 2σn
∞ ∞ ∞ u k
k e−λ k (e λ) Taylor uλ u −1)
3. E[eux ] = euk λ = e−λ euk λk! = e−λ = e−λ ee = eλ(e
P P P
k! k!
k=0 k=0 k=0

4. The missing condition is y ≤ x ≤ y + 2 then using both conditions the probability is

222 2
+ 232
1− 2
242
= 12%

11