Mathematics for Economics and Finance

Midterm Exam
Instructor: Norman Schürhoff

Date: December 19, 2005

Instructions:

• Fill in the required information on every bluebook that you use. Sign every bluebook.

• Bluebooks are provided by the proctor. No other paper is allowed. You must turn in
all sheets, including any scratch paper.

• The exam includes 5 questions on 4 pages. Please count the pages of the exam. If
anything is missing, tell the proctor immediately.

• The duration of the exam is 120 minutes. If you arrive late for the exam, you must
finish with all other students. No extension can be granted.

• 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.

• This is a closed-book exam. You are allowed no other material, including 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. Start the answer to every question at the top of a new page.

• Cheating is prohibited. This includes looking at another student’s work and talking to
other students. Exchanging messages, data or information of any sort with anybody
else is considered cheating. Any active or passive action compromising honorable
conduct is considered cheating. Not following the instructions given in the exam or
by the proctor is considered cheating. Using any material or source of information
not permitted explicitly by the proctor is considered cheating. If you are cheating,
you may fail the exam and the course.

• The total number of points is 60.

1
Question 1 (10 points)
You have just finished your master’s studies at HEC with success. Not surprisingly, you
have been hired as an investment advisor for OBS (Ordinary Bank of Switzerland). Your
first client is a wealthy Saudi-Arabian who wants you to do some asset allocation. The asset
classes he is considering are bonds, stocks, and real estate. You have done some preliminary
analysis and determined that the payoffs of the three types of securities in three possible
scenarios are  
2 1 1
A =  2 −3 2  ,
2 −2 3
where each column is a different asset, and each row is a different scenario.
Your goal is to determine the portfolio allocation in each asset class, denoted θ ∈ R3 , given
the client’s target payoff b ∈ R3 in each scenario. In other words, you want to determine θ
such that Aθ = b. To make sure that this is feasible, you determine the following:
a) Calculate |A|.
b) Is A invertible? Justify briefly.
c) Calculate A−1 .
d) What is the optimal portfolio θ given b = (b1 , b2 , b3 )0 ?

Question 2 (10 points)

For each of the following questions, either provide a function and show briefly that it satisfies
the required conditions, or show why you cannot find such a function:
a) Can you provide an example of a function f : R 7→ R where f is continuous, yet f
fails to attain either a maximum or a minimum?
b) Can you provide an example of a function f : X 7→ R where X is neither closed nor
bounded, f is discontinuous, yet f attains both a maximum and a minimum?
c) Can you provide an example of a function f : X ⊆ R 7→ R where X is nonempty,
closed and bounded, f is continuous, yet f fails to attain either a maximum or a minimum?

Question 3 (10 points)

Determine whether the following statements are true or false (by “false” I mean not neces-
sarily true). In each case, briefly explain your answer and provide some intuition:
a) If a Kuhn-Tucker multiplier is positive, then the corresponding constraint is binding.
b) If a Kuhn-Tucker multiplier is zero, then the corresponding constraint is non-binding.
c) If a constraint is non-binding, then the corresponding Kuhn-Tucker multiplier is zero.
d) If a constraint is binding, then the corresponding Kuhn-Tucker multiplier is positive.

2
Question 4 (15 points)
This is your first day as controller of the new biotech company VALGEN located in Bex,
Valais. Your team has already done a lot of work on optimizing production, but they are
not very fresh on optimization techniques. Luckily, you are because you have just taken a
course on mathematics at HEC.
The team of controllers has determined that given the firm’s production function Y =
f (K, L) = K 1/2 L1/2 with K =Capital, L =Labor, the firm’s cost function is C(Y ; r, w) =
minK,L {rK + wL subject to K 1/2 L1/2 = Y }. Note that r is the cost of capital that the chief
financial officer has provided you, and w is the company’s hourly wage rate including social
charges that the accounting department has provided. Hence, the minimum cost depend on
the output level Y and the factor prices r and w.
The chief financial officer (CFO) of VALGEN has asked you to provide him with the
following information:
a) Find the inputs K and L that minimize cost.
b) What are the minimum cost for Y = r = w = 1?
To make sure that the firm has enough cash to pay all bills once demand rises, the CFO
now asks you to do some sensitivity analysis. In short, the CFO wants to know by how
much the costs change as output rises:
∂C
c) Find ∂Y (1, 1, 1).
The CFO is skeptical that the accounting department has done a good job in coming
up with the factor prices. He comes back to you and asks for some more analysis. In
particular, he asks the following:
d) Show that (with Y = 1) K ∗ (r, w) and L∗ (r, w), the input demand functions, exist for
(r, w) near (1, 1). Otherwise, there would be a problem in hiring sufficient workers.
e) How do the cost depend on the factor prices? That is, find ∂C∂r
(1, 1, 1) and ∂C
∂w
(1, 1, 1).

3
Question 5 (15 points)
You have just become a fund manager at the new CIBERIUS hedge fund in Geneva. Your
managing director asks you to come up with a novel investment strategy that exploits return
predictability in the stock market of several developing countries. You remember from your
finance classes at HEC that stock returns can have different volatility. That means, they
are heteroskedastic. So you consider the following generalized least squares problem. Let

y = Xβ + 

where

E() = 0,
E(0 ) = σ 2 Ω,

and E(·) is the expectation operator. In other words,  is heteroskedastic with variance-
covariance matrix σ 2 Ω (i.e., Ω is a positive definite symmetric matrix).
The problem is you cannot find your econometrics book which would tell you what the
generalized least squares estimator of β is. To solve the problem of finding an estimator for
β yourself, you take three steps. First, you define the standardized error term

∗ ≡ P .

Next, you solve the two remaining problems, which are:

a) Apply a Matrix Decomposition Theorem to find a matrix P such that

E(∗ 0∗ ) = σ 2 I.

That means you try to find a matrix P such that ∗ is homoskedastic (= equal variance).
(Hint: Remember from Econometrics that the expectations operator is linear.)
b) Now use P to derive a least-squares estimator of β. (Hint: You have derived a
least-squares estimator of β in the exercise sessions of your mathematics course at HEC.)

GOOD LUCK!