Mathematics for Economics and Finance

Final Exam
Instructor: Norman Schürhoff

Date: 19.01.2018

Last Name, First Name:

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 ana-
lytical derivations receive no points except if stated otherwise. 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? Only state TRUE or FALSE.

(a) Let A, B be square matrices of the same size, then det((A+B)2 ) = (det(A+B))2 .
(b) If the null space of A is spanned by the the zero vector, then A is invertible.
(c) The kurtosis measures the asymmetry in the distribution, and the skewness mea-
sures the flatness of the distribution.
(d) Let Xn , n = 1, 2, 3, . . . , be a sequence of random variables. If Xn converges to a
random variable X in distribution, then Xn converges to X in probability.
(e) If m is the maximum likelihood estimator of µ, then 2m3 is the maximum likeli-
hood estimator of 2µ3 .
R
(f) If f (x), x ∈ R, is a function such that R f (x)dx = 1, then f (x) is a pdf.
(g) Let f : Rn → R be twice differentiable. If f achieves a local maximum at x∗ , then
the Hessian of f at x∗ is positive semi-definite.
(h) Let f be concave. If x∗ is a stationary point of f , then x∗ is a global maximum.
(i) If A and B are symmetric n × n matrices, then AB must be symmetric as well.
(j) If a function f is strictly concave, then it is also strictly quasi-concave.
(k) If a function f (x) has at least one local minimum, then it also achieves a global
minimum.
(l) The row rank of a matrix A is equal to the column rank if and only if the matrix
A is square.
(m) A random variable is a measurable function from the sample space Ω to the real
line R.

2. Are the following expressions true or false? Only state TRUE or FALSE.

(a) Z
u0 (x) ln u (x) dx = u (x) ln (u (x)) − u (x) − C,

(b)
ZT
∂
V (s, r) = y(s) + rV (s; r), where V (s, r) = y(t)e−r(t−s) dt,
∂s
s

(c)
lim [ln(1 + x) ln(ex − 1)] = 1,
x→0

(d) √
Z 1 Z 1− 3 y
2 e
dy e2x−x dx = .
0 0 2

2
Question I – Solution
1. 1 point per correct answer.
(a) True.
(b) True.
(c) False.
(d) False.
(e) True.
(f) False.
(g) False.
(h) True.
(i) False.
(j) True.
(k) False.
(l) False.
(m) True.

2. 3 points per correct answer.

(a) True.
(b) False.
(c) False.
(d) False.

3
Question II (25 points)
Consider a three asset portfolio problem. Let R = (R1 , R2 , R3 )0 be the returns on the
three assets and assume that the constant expected return model holds: Ri are identically
distributed with expected value µi , variance σi2 , and Cov(Ri , Rj ) = σij . Denote the variance-
covariance matrix by Σ. Let x = (x1 , x2 , x3 )0 denote the shares of wealth invested in each
asset. Assume that all wealth is invested.

1. Provide the expected return on the portfolio, the portfolio variance, and a condition
that assures all wealth is invested (in matrix notation).

2. Show that the portfolio variance is a quadratic form in x1 , x2 and x3 . Define the
definiteness of the quadratic form (PD, ND, PSD, NSD, ID) without performing any
further computations.
 3 1

2
− 2
0
Now let Σ = − 12 32 0 .
0 0 3

3. Check the definiteness of Σ using the eigenvalue criterion.

4. Suppose that you want to minimize the portfolio variance and you are allowed to invest
in only one asset class. Which asset do you choose (that is, what are the optimal
portfolio weights)? What is the portfolio variance in this case?

5. Compute Σ−1 using the Spectral Theorem.

6. Set up the constrained minimization problem to find the portfolio that minimizes the
portfolio variance. Explain why it has a solution.

7. Using the results from the previous questions, find portfolio weights x1 , x2 , and x3 that
minimize the portfolio variance under the condition that all wealth is invested. What
is the portfolio variance in this case? How does your answer differ from question 3?
What do you conclude?
d(x0 Σx)
Hint: remember that dx
= 2Σx.

4
Question II – Solution
1. The expected return on the portfolio is given by µ0 x = µ1 x1 + µ2 x2 + µ3 x3 . The con-
dition assuring that all wealth is invested is x0 1 = 1.

3 points.
2. The portfolio variance can be computed as σ 2 = x0 Σx. Since σ 2 ≥ 0, portfolio variance
matrix is PD.

3 points.
3. The eigenvalues are 1, 2 and 3 so Σ is positive definite.

3 points.
4. If you only invest in one asset class, you will choose the one with smallest variance.
The weights are x = (1, 0, 0)0 or x = (0, 1, 0)0 . The portfolio variance is 3/2 in each
case.

3 points.
5. We have:
 √2 √
− √2 −√ 22 0
   3 1 
1 0 0 4 4
0
2 2 −1 −1 0 1 3
Λ = 0 2 0 , Ĉ = − 2
  
2
0 and Σ = ĈΛ Ĉ = 4 4 0  .
 
0 0 3 0 0 1 0 0 13
5 points.
6. The optimization problem can be written as :
min f (x) = x0 Σx
x
s.t. x0 1 = 1
The constraint set is closed and bounded, so by the Weierstrass’ theorem there exists
a solution to the problem. Also note that H(f (x)) is positive definite (f is convex).

3 points.
7. Setting up a Lagrangian and taking FOCs gives:
∂L ∂L
L(x, λ) = x0 Σx − λ(x0 1 = 1) ⇒ = 2Σx − λ1 = 0, = x0 1 − 1 = 0.
∂x ∂λ
From the first FOC we can compute λ and plug it into the second FOC, resulting in:
2 Σ1
λ= 0 , x= 0 .
1 Σ1 1 Σ1
The resulting portfolio allocation is x = (0.4268, 0.4268, 0.1429)0 and portfolio vari-
∗

ance 0.3741. The result is much lower than in point 4, due to diversification.

5 points.

5
Question III (25 points)
Consider a consumer who seeks to maximize her utility subject to a budget constraint. There
are two goods x1 and x2 with prices p1 and p2 . The income of the consumer is I and her
utility function in the two goods is u(x1 , x2 ) = x1 + ln(x2 ). Note that the consumer cannot
consume a negative amount of goods.

1. Set up the optimization problem in standard notation and characterize the constraint
set by a complete set of equalities and inequalities.

2. Explain briefly if a solution to the problem is guaranteed to exist?

3. Is constraint qualification satisfied? What does this imply?

4. Can the Kuhn-Tucker method be applied to this optimization problem? If yes, formu-
late all KT conditions. If not, explain why.

5. Solve the optimization problem.

Hint: Before you begin, make an educated guess by looking at the objective func-
tion and the first-order conditions in order to reduce the number of cases.

6. Assume that p1 < I. Specify the value function in this case. How do the solution and
the value function depend on p1 and p2 ?

6
Question III – Solution
1. The optimization problem in a standard form:

u(x1 , x2 ) = x1 + ln x2 → max
x1 ,x2

s.t. p1 x1 + p2 x2 ≤ I
x1 ≥ 0
x2 ≥ 0

The constraint set is given by:

D = {(x1 , x2 ) s.t. p1 x1 + p2 x2 ≤ I, x1 ≥ 0, x2 ≥ 0}

3 points.

2. The objective is continuous and the constraint set is compact (closed and bounded,
because it is clearly implied by the budget constraint or inequalities etc.). Thus, by
Weierstrass’ theorem the objective function possesses a maximum on D.

3 points.

3. The constraints are linear =⇒ constraint qualification is satisfied. Thus, the KT Con-
ditions are necessary for an optimal solution.

3 points.

4. KT Conditions:

L(x1 , x2 , λ, µ1 , µ2 ) = x1 + ln x2 + λ(I − p1 x1 − p2 x2 ) + µ1 x1 + µ2 x2

Lagrange conditions:
∂L
= 1 − λp1 + µ1 = 0 (first condition)
∂x1
∂L 1
= − λp2 + µ2 = 0 (second condition)
∂x2 x2
Complementary slackness conditions:

λ(I − p1 x1 − p2 x2 ) = 0
µ1 x1 = 0, µ2 x2 = 0
λ ≥ 0, µ1 ≥ 0, µ2 ≥ 0
x1 ≥ 0, x2 ≥ 0, p1 x1 + p2 x2 ≤ I

6 points. If stated that KT cannot be applied, we added 1 point if Lagrangian and

FOC were correct.

7
5. There are 23 possibilities.

(a) λ = 0, µ1 = 0, µ2 = 0
(b) λ = 0, x1 = 0, µ2 = 0
(c) λ = 0, x1 = 0, x2 = 0
(d) λ = 0, µ1 = 0, x2 = 0
(e) I − p1 x1 − p2 x2 = 0, µ1 = 0, µ2 = 0
(f ) I − p1 x1 − p2 x2 = 0, x1 = 0, µ2 = 0
(g) I − p1 x1 − p2 x2 = 0, x1 = 0, x2 = 0
(h) I − p1 x1 − p2 x2 = 0, µ1 = 0, x2 = 0

Let’s first reduce the potential solutions.

(a) check if it it is possible that x2 = 0

(second condition)=⇒ 10 − λp + µ2 = 0 not possible,
=⇒ x2 6= 0
=⇒ cases (c) (d) (g) and (h) are not possible
(b) check if λ = 0
(first condition) =⇒ 1 − 0 + µ1 = 0 =⇒ µ1 = −1 < 0 =⇒ not possible,
hence λ 6= 0, and cases (a) and (b) are not possible.
There are only cases (e) and (f) left.

(c) case (e)

I − p1 x1 − p2 x2 = 0 =⇒ λ ≥ 0
µ1 = 0 =⇒ x1 ≥ 0
µ2 = 0 =⇒ x2 ≥ 0
1
(first condition) =⇒ 1 − λp1 = 0 =⇒ λ = p1
> 0.
(second condition) =⇒ 1
x2
− λp2 = 0 =⇒ 1
x2
− pp21 = 0 =⇒
x2 = pp12 > 0.
I − p1 x1 − p2 pp12 = 0
I−p1
x1 = p1
≥ 0, if I ≥ p,

=⇒ if I ≥ p, x1 = I−p
p1
1
≥0
p1
x2 = p 2 > 0
λ = p11 ≥ 0
µ1 = 0
µ2 = 0
I − p1 x1 − p2 x2 = 0.
(d) case (f)
I − p1 x1 − p2 x2 = 0 =⇒ λ ≥ 0

8
 x1 = 0 =⇒ µ1 ≥ 0
µ2 = 0 =⇒ x2 ≥ 0
I
I − 0 − p2 x2 = 0 =⇒ x2 = p2
> 0.
1 1 I 1
(second condition) =⇒ x2
− λp2 = 0 =⇒ x2 = λp2
, x2 = p2
=⇒ λ = I
(first condition) =⇒ 1 − λp1 + µ1 = 0
1 − pI1 + µ1 = 0 =⇒ µ1 = p1I−I ≥ 0 if p1 ≥ I
if p1 ≥ I =⇒ x1 = 0
x2 = pI2 ≥ 0
µ1 = p1I−I ≥ 0
µ2 = 0
λ = I1 ≥ 0
I − p1 x1 − p2 x2 = 0.

Thus the answer is given by:

p1 > I =⇒ x1 = 0
I
x2 = p2
.
I−p1
p1 ≤ I =⇒ x1 = p1
p1
x2 = p2
.

6 points.

6. The value function is given by:

 
I − p1 p1
v(p1 , p2 ) = + ln .
p1 p2

To find the properties of the solution and the value function, we need to compute their
derivatives w.r.t. the corresponding parameters:
∂x∗1 ∂x∗1
∂p1
= − pI2 < 0, ∂p2
=0
1
∂x∗2 1 ∂x∗2
∂p1
= p1
> 0, ∂p2
= − p11p2 < 0
∂v
∂p1
= − p2 + p11 <
I
0, ∂v
∂p2
= − p11p2 < 0
1

4 points.

9
Question IV (25 points)
Suppose that X, Y , and e are random variables and let

Y = α + βX + e.

Assume further that E(X) = 0 and V ar(X) = σ 2 . The random variable e has a uniform
distribution over [− 12 , 12 ] and Cov(X, e) = 0.

1. What is the distribution of Y conditional on X = x? That is, what is f (Y |X = x)?

2. What are E [Y |X] and V ar [Y |X]?

3. What are E [Y ] and V ar [Y ]? Explain how and why your answer differs from the
answer to question 2.

Now you are interested in another model:

Y = βX + e.

Assume you observe a random sample of n iid observations of (Xi , Yi ). Let the distribution
of e conditional on X = xi be

e|(X = xi ) ∼ iid N (0, θ2 ),

which implies that the distribution of Y conditional on X = xi is

Y |(X = xi ) ∼ N (βxi , θ2 ).

4. Find the maximum likelihood estimators for β and θ2 .

Hint: use the conditional pdf of e to compute the likelihood function.

5. Show that the maximum likelihood estimator for β is unbiased.

6. Compute the Fisher information matrix and the Cramér-Rao lower bound.

7. Is the maximum likelihood estimator of β the best unbiased estimator of β?

8. Find the joint asymptotic distribution of the estimators.

10
Question IV – Solution
1. The distribution of Y , conditional on X = x is the distribution of Y , where e is the
only random variable and α + βX is fixed.. This distribution of Y = α + βx + e is thus
uniform α + βx − 21 , α + βx + 12 .


f (Y |X) = 1.

3 points.
a+b (b−a)2
2. If U is distributed uniformly on [a, b] then: E [U ] = 2
, V ar [U ] = 12
. Therefore:
1 1 2
α+βX− 12 +α+βX+ 12 ((α+βX+ 2) (
− α+βX− 2 )) 1
E [Y |X ] = 2
= α + βX, V ar [Y |X ] = 12
= 12 .

3 points.

3. E [Y ] = E [α + βX + e] = α, V ar [Y ] = V ar [α + βX + e] = β 2 V ar [X] + V ar [e] +
1
2βCov [X, e] = β 2 σ 2 + 12 .

3 points.

4. The likelihood function is given by

" n
# " n
#
−n/2 1 X −n/2 1 X
L(Y ; X, θ) = 2πθ2 (ei )2 = 2πθ2 (Yi − βXi )2 .



exp − 2 exp − 2
2θ i=1 2θ i=1

The log likelihood function is then

n n n
!
n n 1 X X X
lnL = − ln 2π − ln θ2 − 2 Yi2 − 2β Yi X i + β 2 Xi2 .
2 2 2θ i=1 i=1 i=1

The score vector is defined by the FOC. Let γ = θ2 ,

n n
! Pn
∂ ln L 1 X X
2 Xi Yi
=− −2 Yi Xi + 2β̂M LE Xi = 0 ⇒ β̂M LE = Pi=1
n 2
.
∂β 2γ i=1 i=1 i=1 Xi
n
∂ ln L n n X
=− + 2 (Yi − βXi )2 = 0.
∂γ 2γ 2γ i=1
n
n 1 X
⇒− + 2 (Yi − β̂M LE Xi )2 = 0
2γ 2γ i=1
n n
1X 1X 2
⇒ γ̂M LE = (Yi − β̂M LE Xi )2 ≡ ê .
n i=1 n i=1

4 points.

11
5. β̂M LE is unbiased if and only if E(β̂M LE ) = β.
Pn  n
i=1 Xi Yi 1 X
E P n 2
= n
P 2
Xi × βXi = β.
i=1 Xi i=1 Xi i=1

Thus the maximum likelihood estimator of β is unbiased.

3 points.
6. Second order derivatives:
n
∂ 2 ln L 1X 2
=− X .
∂β∂β γ i=1 i
n
∂ 2 ln L n 1 X
= − (Yi − βXi )2 .
∂γ 2 2γ 2 2γ 3 i=1
n
∂ 2 ln L 1 X
=− 2 (Yi − βXi )Xi .
∂β∂γ γ i=1

The Fisher Information Matrix is given by

− γ1 ni=1 Xi2 − γ12 ni=1 (Yi − βXi )Xi 1
Pn
Xi2
 P P   
γ i=1 0
I(β, γ) = −E = .
− γ12 ni=1 (Yi − βXi )Xi 2γn2 − 2γ13 ni=1 (Yi − βXi )2 n
P P
0 2γ 2

The Cramér-Rao lower bound:

−1 −1
γ ( ni=1 Xi2 ) θ2 ( ni=1 Xi2 )
 P   P 
−1 0 0
I(β, γ) = 2 2 = 2 4 .
0 n
γ 0 n
θ

3 points.
7. The Cramér-Rao lower bound tells us that, for any unbiased estimator β̂ of β, we have:
1
V(β̂) ≥ .
I(β)
We showed earlier that the ML estimator is unbiased and if its variance matches the
above lower bound, then we know that it will also be the best unbiased estimator of
β. Therefore we have to compute V(β̂M L ):
 Pn n
! P
n 2 2
θ2

i=1 xi yi 1 i=1 xi × θ
X
2
V(β̂M L ) = V n = X V(yi ) = = n 2.
2
( ni=1 x2i )2 i=1 i ( ni=1 x2i )2
P P P P
i=1 xi i=1 xi

Clearly the variance of the estimator reaches the lower bound, as such β̂M LE is the
best unbiased estimator of β.

3 points.

12
8. The asymptotic distribution is given by

√
    2 Pn −1 
β̂M LE − β d σ ( i=1 Xi2 ) 0
n 2 2 → N 0, 2 4 .
σ̂M LE − σ 0 n
θ

3 points.

13