Review session, 19 October 2018

Mathematics for Economics and Finance

Prof: Norman Schürho↵
TAs: Jakub Hajda, Jimmy Lerch

Exercise 1
Let Q be the following quadratic form:

Q = x21 + 2x22 + 2x23 2x1 x2 2x1 x3 .

(a) Write the quadratic form in matrix notation (i.e. Q = xT Ax) .
(b) Compute the eigenvalues of matrix A. check the definiteness of Q using eigenvalues of A.
(c) Compute the orthonormal eigenvectors of A.
(d) Calculate explicitly An as a function of n.
(e) Compute the inverse matrix of A using the Spectral theorem.

0 1 0 1
Solution 1 x1 1 1 1
(a) Q = xT Ax where x = @ x2 A and A = @ 1 2 0 A
x3 1 0 2
2 3
1 1 1
(b) det(A In ) = 0 , 4 1 2 0 5 = 0 , (1 )(2 )2 (4 2 ) = 0 , 3 5 2 + 6 = 0
1 0 2
Thus, we have 3 eigenvalues: 1 = 0, 2 = 2, 3 = 3. Two are positive, and one is equal to zero. This
implies that the quadratic form Q is positive semidefinite.

(c) for 1 = 0: 0 1 0 1
1 1 1 1 1 1
(A In ) = @ 1 2 0 A row 2 and row 3 + row 1 and finally row 2+row 3 ! @ 0 1 1 A
1 0 2 0 1 1
0 10 1 0 1
1 1 1 x1 0 ⇢
x1 = 2x2
!@ 0 1 1 A @ x2 A = @ 0 A )
x2 = x3
0 0 0 x3 0
0 1
2c
) x1 = @ c A 8c 2 R =) 1 = 0
c
) To get the orthonormal eigenvectors, we need to rescale the eigenvector
p by his norm
p such that the new
norm is01. Putting
1 c constant and equal to 1, The actual norm is 22 + 12 + 12 = 6, so:
p2
6
B p1 C
x̂1 = c @ 6 A =) 1 =0
p1
6

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 for 1 = 2: 0 1 0 10 1 0 1
1 1 1 1 1 1 x1 0 ⇢
x1 = 0
(A In ) = @ 1 0 0 A !@ 1 0 0 A @ x2 A = @ 0 A )
x2 = x3
1 0 0 0 0 0 x3 0
0 1
0
) x2 = @ c A 8c 2 R =) 2 =2
c
0 1
0
1
x̂2 = c @ p2 A =) 2 = 2
p1
2

for 1 = 3: 0 1 0 1 0 10 1
2 1 1 1 0 1 1 0 1 x1
(A In ) = @ 1 1 0 A row 1 minus row 2 ! @ 1 1 0 A !@ 1 1 0 A @ x2 A =
0 1 1 0 1 1 0 1 0 0 0 x3
0 ⇢
@ 0 A) x1 = x2
x2 = x3
0
0 1
c
) x3 = @ c A 8c 2 R =) 3 =3
0 c1
p1
3
B p1 C
x̂3 = c @ 3 A =) 3 =3
p1
3

(d) Because A is a symmetric matrix, we could in principle decompose the matrix A = Ĉ⇤Ĉ 0 .

• Ĉ = (x̂1 , x̂2 , x̂3 )

• ⇤ = diag( 1, 2, 3)

Because Ĉ is an orthogonal matrix (by definition), Ĉ 0 Ĉ = In . From this statement, one may note that
An = Ĉ⇤Ĉ 0 Ĉ⇤Ĉ 0 ...Ĉ⇤Ĉ 0 = Ĉ⇤n Ĉ 0 ,
0 1n 0 1
0 0 0 0 0 0
where ⇤n = @ 0 2 0 A = @ 0 2n 0 A .
0 0 3 0 0 3n
(e) Because one of the eigenvalues is equal to 0, we can’t find an inverse.
But assuming we can, from definition 2.22 of the lecture notes, we know that the inverse matrix of A is
just Ĉ⇤ 1 Ĉ 0 . By using the spectral decomposition in this specific case (when the matrix is symmetric), we
don’t need to do any inverse computation:

• Ĉ doesn’t change.
0 0
1
1 0 0
• ⇤ 1
=@ 0 1
2 0 A.
1
0 0 3

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 • We know everything to compute the inverse matrix. But in our case, as told before, there is no
inverse matrix!

Exercise 2
Find the following limits:

(a)
5x2 sin(3x)
lim
x! 1 x2 + 10
(b)
cos( n
1
)
lim n2 (e1 1).
n!1

Solution 2
(a) Apply the sandwich theorem, the limit is equal to 5.
(b)
1
1 e1 cos n 1
lim n2 (e1 cos n 1) = lim 1
n!1 n!1
n2
1 cos t
e 1
= lim
t!0 t2
L’Hopital sin te1 cos t
= lim
t!0 2t
2
L’Hopital (sin t) e1 cos t + cos te1 cos t
= lim
t!0 2
1
= .
2

Exercise 3
Let G be an open set in R. F is a closed subset of R. The point x 2 R belongs to the boundary of both sets.
For each of the following statements, explain briefly why it is true or false.

(a) x 2 G.
(b) x 2 F .

(c) x 2 F \G.

Solution 3
(a) x 2 G. False. Since G is an open set it does not include any of its boundary points.
(b) x 2 F . True. Closed set F includes all its boundary points.

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 (c) x 2 F \G. True. Set F \G includes all points of set F which are not points of set G. Point x is just such a
point as has been shown above.

Exercise 4
Discuss whether the following sets are closed, open, bounded or unbounded:
(a) {(x, y) : x and y are integers},
(b) {(x, y) : x + y < 1},

(c) {(x, y) : x = 0 or y = 0}.

Solution 4
(a) This set is closed and unbounded. The unboundedness property is obvious. The fact that {(x, y) : x and y are integers}
is closed comes from the fact that its complement set S c , i.e. the union of all open intervals between integer
numbers, is open.

(b) This set is open and unbounded. Contrary to the example before we have now a whole area. It is open
because the boundary does not belong to the set and that it is unbounded is obvious.
(c) This set is closed and unbounded. The unboundedness property is obvious and the argumentation of the
closeness goes over the openness property of the complement set.

Exercise 5
You are an asset manager responsible for managing Harvard’s endowment fund. 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 portfolio 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
2 3
2 C 0
A = 4 C 2 0 5.
0 0 4

(a) [1.] If you assume that you invest W , what is w1 + w2 + w3 ?

[2.] 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?
[3.] If you assume that you invest W , what is the expected increase/decrease of W for the holding period?
(b) [1.] Does A satisfy any of the following properties: symmetric, orthogonal, idempotent? Specify the
parametric requirements on C if necessary.
[2.] Prove that the matrix I A(A0 A) 1
A0 is idempotent, with I the rank 3 identity matrix?

(c) Suppose you want to minimize the portfolio variance V and you are allowed to invest in only one asset class:
[1.] Which asset do you choose (that is, what are the optimal portfolio weights w1 , w2 , and w3 )?

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 [2.] What is the portfolio variance in this case? Hint: Variance of an asset is the corresponding diagonal
element in matrix A. Variance of a portfolio solves w0 Aw, where w = (w1 , w2 , w3 )0 .
(d) Suppose that the eigenvalues of the matrix A are 1, 3 and 4. What are the possible values of C?

For the next questions assume that: the eigenvalues of A are 1, 3 and 4, and C = 1.

(e) Find the eigenvectors corresponding to the eigenvalues of A.

(f) Compute A 1 in two ways: using one of the methods to invert the matrix discussed during the class and
by means of the spectral decomposition of A.

(g) Determine the definiteness of the covariance matrix A.

A 11
(h) The minimum variance portfolio M V is 10 A 1 1 , where 1 is equal to (1, 1, 1)0
[1.] Find the weights that permit to minimize the variance of the portfolio i.e. compute M V .
[2.] What is the variance of the portfolio now? Compare your answer with your solution in 3 and explain
the di↵erence.

(i) The tangency portfolio is the portfolio of risky assets that has the highest Sharpe’s ratio and can be expressed
A 1 (µ r 1)
as 10 A 1 (µ rff 1) , where rf is the risk-free rate and µ = [0.02; 0.03; 0.08]0 . Assume that rf = 0 and recompute
points 8 (a) and 8 (b). Compare with previous results and provide a brief comment.

Solution 5
(a) 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 ).

(b) A is always symmetric as A0 = A. A is neither orthogonal nor idempotent.

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.
(c) Without diversification, you invest only in the asset with the lowest variance and so here the first two assets
are equivalents, the solutions are (1, 0, 0) or (0, 1, 0). The portfolio variance is 2.
0 1
2 C 0
(d) det(A I) = det @ C 2 0 A=
0 0 4
= (4 )[(2 )2 C 2 ]
If we know that one eigenvalue is 4 then (2 )2 C 2 = 0. By substituting the two remaining eigenvalues
(both of which have to solve the equation) we get C = 1 or C = 1.

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(e) The corresponding eigenvectors matrix G is the following:
0 p p 1
2 2
0
B p2 p 2 C p2
@ 2
2
2
2
0 A, 2 ' 0.7071.
0 0 1
0 2 1
1
3 3 0
(f) Using previous result: A 1 = @ 13 2
3 0 A.
1
0 0 4
Spectral decomposition: by definition 2.22, p.62, A = G⇤G0 and A 1
= G⇤ 1
G0 .
(g) The variance of the portfolio V = (w1 , w2 , w3 )A(w1 , w2 , w3 )0 . We can compute the leading principal minors
of A.
D1 > 0,
D2 > 0,
D3 = 4D2 > 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 11
(h) 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 15
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 ) = 11 '
1.36. The variance is significantly below the variance found in question 3 thanks to diversification.