Exercise Session 12, Solutions, December 1st ,2006

Mathematics for Economics and Finance

Prof: Norman Schürho¤
TAs: Zhihua Chen (Cissy), Natalia Guseva

Problem 1 OLS estimator in …nite sample. Recall b = (X 0 X) 1

X 0Y

1. Find the sampling error. (Hint: b )

2. Show OLS estimator is unbiased. (Hint: E(b j X) = )

3. Find the variance of b for given X:

Solution
1. The sampling error:

b = (X 0 X) 1 X 0 y
= (X 0 X) 1 X 0 (X + ")
= (X 0 X) 1 X 0 X + (X 0 X) 1
X 0"
| {z }
=In

= (X 0 X) 1
X 0"

2. To show E(b j X) = is equivalent to show E(b j X) = 0;

set A = (X 0 X) 1 X 0 ;then

E(b j X) = E(A" j X)
A is X m easurable
= AE(" j X) = 0 by Assumption E(" j X) = 0

3.

V ar(b j X) = V ar(b j X)....since is true value, V ar( ) = 0; Cov( ; b) = 0:

= V ar(A" j X) A is X measurable
0
= AV ar(" j X)A ......Notes: E(" j X) = 0
= AE(""0 j X)A0
0 2
= A 2 In A0 ......By assumption E("" j X) = In homoskedasticity
2
= (X 0 X) 1 X 0 [(X 0 X) 1 X 0 ]0
2
= (X 0 X) 1 X 0 X [(X 0 X)0 ] 1
| {z }
In
2 0 1
= (X X)

1
Problem 2 Let ( ; F; P) be a probability space. There exists two random vari-
ables X and Y . If we can observe X,what we can Rsay about Y ? One way is to
2
use mean square error, M SE = E(Y g(X))2 = fY (!) g(X(!))g dP (!).
Show that g (X) = E(Y j X) is the best solution.
Solution
M SE = E[Y g(X)]2
= E[Y E(Y j X) + E(Y j X) g(X)]2
= E[Y E(Y j X)]2 + E[E(Y j X) g(X)]2
+2Ef[Y E(Y j X)][E(Y j X) g(X)]g
| {z }
(3)

(3) = 2EfE[(Y E(Y j X)) (E(Y j X) g(X)) j X]g

| {z }
X m easurable, take out one exp ectation
= 2Ef(E(Y j X) g(X))E[(Y E(Y j X)) j X]g
= 2Ef(E(Y j X) g(X))(E(Y j X) E(Y j X))g
| {z }
=0
= 0
)
M SE = E[Y E(Y j X)]2 + E[E(Y j X) g(X)]2
| {z }
0
2
) E[Y g(X)] E[Y E(Y j X)]2
which implies g (X) = E(Y j X) minimizes MSE.

2
Problem 3 Variable X is normally distributed with mean and variance .
1. Assume 2 = 80: The observed value of the sample mean X of a random
sample of size 20 is 81:2. Find a 95% con…dence interval for .
2
2. Assume = 9:Find n such that P r(X 1< < X + 1) = 0:9 approxi-
mately.
Solution
2
2
if X s N ( ; ) then X s N ( ; n )
p
1. CI95% ( ) = (X F 1
(0:975) pn ; X + F 1
(0:975) pn ) = (81:2 1:96 p80
20
;
p
81:2 + 1:96 p80
20
) = (77:28; 85:12)

1
2. Pr(X 1 < < X + 1) = 0:9 =) CI90% ( ) = (X F (0:95) pn ;
1
X + F (0:95) pn ) = (X 1; X + 1) =)
p
F 1 (0:95) pn = 1 =) n = F 1 (0:95) = 1:645 3 = 4:935 =) n t 24

2
Problem 4 Show for any two random variables X and Y ,
V arX = E(V ar(X j Y )) + V ar(E(X j Y )):

Solution By de…nition, we have

V arX = E(X EX)2

= E[X E(X j Y ) + E(X j Y ) EX]2
| {z }
add and subtract
2 2
= Ef(X E(X j Y )) + (E(X j Y ) EX)
+2 (X E(X j Y )) (E(X j Y ) EX)g
2 2
= E (X E(X j Y )) + E (E(X j Y ) EX)
| {z } | {z }
(1) (2)

+2E[(X E(X j Y )) (E(X j Y ) EX)]...by linearity property

| {z }
(3)

(3) = 2EfE[(X E(X j Y )) (E(X j Y ) EX) j Y ]g by law of iterated exp.

| {z }
EX cons.& E(XjY ) Y m easable

= 2Ef(E(X j Y ) EX) E[(X E(X j Y )) j Y ]g Take out what is known

| {z }
from now on, fo cus this part
= 2Ef(E(X j Y ) EX) [E(X j Y ) E(E(X j Y ) j Y )] g...by linearity property
| {z }
=E(XjY ) By taking out what is known

= 2Ef(E(X j Y ) EX) [E(X j Y ) E(X j Y )]g

| {z }
=0
= 0:

2
(1) = E[E (X E(X j Y )) j Y ]....by law of iterated expectation
2
= EfE[X 2 + (E(X j Y )) 2XE(X j Y ) j Y ]g
2
= E[E(X j Y ) + (E(X j Y ))2
2
2 (E(X j Y )) ]...by linearity & take out known
2
= E[E(X 2 j Y ) (E(X j Y )) ] = E[V ar(X j Y )]
(2) = E[E 2 (X j Y ) + E 2 (X) 2E(X)E(X j Y )]
= E(E 2 (X j Y )) + EE 2 (X) 2E(X)E(E(X j Y ))
| {z } | {z }
=E 2 X =EX
2 2
= E(E (X j Y )) (E(E(X j Y ))) = V ar(E(X j Y )):

) V arX = E(V ar(X j Y )) + V ar(E(X j Y )):

3
Problem 5 Suppose the distribution of Y conditional on X = x is N (x; x2 )
and the marginal distribution of X is uniform (0; 1):Find EY; V arY; and Cov(X; Y ):

Solution
1
Notes the pdf for X is fX (x) = 1 0 = 1;because X is uniform in (0; 1):

law of iterated exp.

EY = E(E(Y j X))
| {z }
=X
Z1 Z1
x2 1 1
= EX = x fX (x)dx = x 1dx = j =
2 0 2
0 0

V arY = E(V ar(Y j X)) + V ar(E(Y j X)) use Q3 result

| {z } | {z }
X2 X
2
= EX + V arX
2
= EX 2 + EX 2 (EX)
2
= 2EX 2 (EX)
Z1 2
1
= 2 x2 fX (x)dx
2
0
x3 1 1 5
= 2 j =
3 0 4 12

Cov(X; Y ) = E(XY ) EXEY

x 1 1
= E(E(XY j X)) ...law of iterated expectation
2 2
1
= EXE(Y j X) ......take out what is known
| {z } 4
=X

2 1
= EX
4
Z1
1 1 1 1
= x2 fX (x)dx = = :
4 3 4 12
0