2023 FIN2210 Problem Set 12

Probability for Finance

1. Let be unbiased estimators of a parameter with Var 2 and Cov(

W1 ,…,Wk θ W i =σ

W i , W j) = 0 if i≠ j.
k
(a) Show that, of all estimators of the form , where the s are constants and
∑ ai W i ai
i=1

∑ W i /σ 2i
(∑ )
k
ai W i =θ, the estimator W = k has minimum variance.
¿ i=1
Eθ
i=1
∑ 1/σ 2i
i=1

1
(b) Show that Var = k .
(W ¿ ¿¿)¿
∑ 1/σ 2
i
i=1

2. A random sample, X 1 , … , X n, is taken from an i.i.d. population with ( μ , σ 2). Consider

the following estimator of μ:
n
2 2
^μ= ∑
n (n+1) i=1
i∙ X i=
n ( n+1 )
(X 1+2 X 2 +3 X 3 + …+nX n )

(a) Show ^μ is unbiased for μ.

n
(b) Which estimator, or , is more efficient? Explain. [Hint: n ( n+1 )
^μ Xn ∑ i= 2
∧¿
i=1

n
n ( n+1 ) (2n+1) ]
∑ i 2= 6
i=1

3. Suppose ( X 1 , X 2 , … , X n) is an i.i.d. N( μ , σ 2) random sample. Define

n
S2n= ( n−1 )
−1
∑ ( X i−X n ) 2 ,
i=1

n
Where ; and
X n=n−1 ∑ X i
i=1
 n
2
σ^ =n
n
−1
∑ ( X i−X n ) 2
i=1

(a) Are and unbiased estimators for 2? (b) Show which estimator is more
σ^ n
2 2
Sn σ

efficient. Give your reasoning.

4. Suppose n is an IID random sample from a Poisson distribution with

X =( X 1 , … , X n ) (α )

probability mass function

x
−α α
f X ( x )=e for x=0 , 1 ,2 , … ,
x!
Where α is unknown.
(1) Find the MLE for α .
(2) Is the MLE for α the best unbiased estimator for α ?
5. Suppose X n is an IID random sample from the N(µ,σ 2) population, where µ is unknown
but is known. Consider a test statistic T = at the significance level α for
σ
2
√ n( X n−μ0 )/σ
H0: µ = μ0 versus HA: µ≠ μ0.
1) Find Type I error of this test;
2) Find Type II error of this test;
3) Derive the power function of this test under the alternative HA: µ = μ0+δ, where δ≠ 0.
What happens to the power of the test if |δ| increases? And What happens to the
power of the test if the sample size n increases?

6. Suppose we want to find out whether mutual funds outperform the stock market. We collect
data on monthly returns, and model them using log-normal distribution. That is, we assume
. We can calculate the difference between
ln R Stock N ( μS , σ 2S ) , ln RFund N ( μF , σ 2F ) ln R Stock

and
ln R Fund in each month, and it should also follow a normal distribution N ( μ D , σ 2D ).

Summary statistics are presented below.

N Mean Standard Deviation
ln R Stock 192 0.0099 0.0544
ln R Fund 192 0.0106 0.0850
Difference 192 0.0007 0.0430
a) What should the null and alternative hypotheses be?
b) What should the test statistics be? What is its distribution?
c) Do you reject the null? You can use Q ( 95 % ) ≈ 1.653 for t-distribution with around 200
 degrees of freedom.
d) If the true value for μ D is 0.001, what is the probability of type-II error?

7. In a football game, the shot attempt a team makes in a game follows a Poisson(15)
distribution. However, if the team is bribed to lose the game, the shot attempt follows a
Poisson(5) distribution. In a particular game, you observe the shot attempt for one team is
X =6. You wonder if the game is fixed, that is, this team intentionally tries to lose. For your
information, the CDF of Poisson is given in the table.
0 1 2 3 4 5 6 7 8 9
Poisson(15 0.00 0.00% 0.00% 0.02% 0.09% 0.28% 0.76% 1.80% 3.74% 6.99%
) %
Poisson(5) 0.67 4.04% 12.47 26.50 44.05 61.60 76.22 86.66 93.19 96.82
% % % % % % % % %
a) What should the null and alternative hypotheses be? Recall that we typically assume
innocence until proven guilty.
b) What should the test statistics be?
c) Suppose you want to be 99% sure before you make the accusation. What is your
judgement (i.e., do you reject the null)?
d) If the game is indeed fixed, what is the probability of type-II error?