Mathematics for Economics and Finance (Fall 2022)

Problem Set 1 (Optional): Sets, functions, logic, proofs

Professor: Roxana Mihet
TA: Eliott Gabrielle
You do not need to hand in any solutions!
Out: Sept 19; In: Sept 23

1 Exercise: Sets
The consumption set of a consumer is:

C = {(x, y) ∈ R2 : x ≥ 0, y ≥ y 0 > 0} (1)

Illustrate this set. How would you interpret y 0 ?

2 Exercise: Functions
Let L(X, Y ) be the vector space of all linear mappings from vector space X to vector space Y . Let
T ∈ L(Y, Z),S ∈ L(X, Y ). Show that the composition of the two linear functions, T (S(.)), is linear.

3 Exercise: Functions
Prove there exists a bijection between the natural numbers and the integers. (Hint: define a function f
separately on the odd and even positive integers.)

4 Exercise: Logic
Negate the statements:

1. For all x, there is y such that for all z: z > x , z > y.

2. ∀x ∈ R, ∃(y, z) ∈ R2 such that y < x < z.

3. ∀(y, z) ∈ R2 , y < z, ∃x ∈∈ R such that y < x < z.

4. There is a country in which every citizen has a friend who knows all the constellations.

5. In every village, there is a person who knows everybody else in that village.

5 Exercise: Indirect proof

Suppose there are 400 new bachelor students enrolled in HEC this year. Prove that at least two of them
celebrate their birthdays on the same day (Hint: use indirect proof).

1
6 Exercise: Induction
n(n+1)(n+2)
Prove that 1×2+2×3+...+n×(n+1) = 3 for all natural n > 1. (Hint: use mathematical induction).

7 Exercise: Application of Induction

Consider a 10 years coupon bond. The coupon payments are annual and equal to $1, the face value is $2 and
the rate of return on this bond is 2%. Compute the price of the bond. What is the price of the perpetual
bond? (Hint: Compute S = 1 + k + k 2 + k 3 + .. + k n first.)

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 2: Linear algebra I
Professor: Roxana Mihet
TA: Eliott Gabrielle
You do not need to hand-in your answers
Due September 30th

1 Exercise: Proof by induction

Show that for all n and for all x 6= 1,

1 − xn+1
1 + x + x2 + ... + xn = (1)
1−x

Hint: You can do this by direct proof, or by induction.

2 Exercise: Proof by induction

2
Prove that Sn = 13 + 23 + . . . n3 = (1 + 2 + · · · + n) for all natural n. (Hint: use mathematical induction).

3 Exercise: Rank, determinant, trace, inverse of a matrix

1. Compute
3 1 −1 2
−5 1 3 −4
D= .
2 0 1 −1
1 −5 3 −3

2. Calculate rank(A), |A|, tr(A), A−1 for

 
1 4 7
A= 3 2 5 .
 

5 2 8

4 Gaussian Elimination Method

For the matrix below  
3 2 4
A= 2 0 2 .
 

4 2 3

Find its inverse using Gaussian elimination and answer if the matrix is 1) symmetric, 2) idempotent, 3)
orthogonal.

1
5 Exercise: true or false?
Consider a matrix Am×n . Which of the following statements are true and which are false? Explain why.

1. If the rows of matrix A are linearly independent, then m > n.

2. If the rows of matrix A are linearly dependent, then m > n.

3. If m > n, then the rows of matrix A are linearly independent.

4. If m > n, then the rows of matrix A are linearly dependent.

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 3: Linear algebra: systems of equations
Professor: Roxana Mihet
TA: Eliott Gabrielle
Due Oct 7nd

1 Exercise: Using linear algebra to verify market completeness

 
x11 ......x1n
 x ......x 
 21 2n 
There are n different states of nature and m assets in economy. X =   is a payoff matrix,
 : 
xm1 ......xmn
where each column corresponds to each state and each row shows how much an asset gives in each particular
state. Financial market is complete if by means of existing assets one can construct a portfolio which will
give any desired combination of payoffs in different states. If there are more assets than needed to construct
such a portfolio then assets which are not used in a portfolio are called redundant.

1. If the market is complete, what is the relation between m and n (n ≤ m, m ≤ n or no relation)?

2. If the market is complete what can you say about the rank of matrix X?

3. What is a condition for absence of redundant assets?

 
301
4. Consider an economy with 3 states and 3 assets. The payoff matrix is: X =  5 1 4  . Is this market
 

919
complete? Are there any redundant assets?
 
135
 113 
5. Consider an economy with 3 states and 4 assets. The payoff matrix is: X =   . Is this
 
 3 9 15 
5 5 15
market complete? Are there any redundant assets?

2 Determinant, inverse
Calculate det(A), A−1 for  
1 4 7
A= 3 2 5 .
 

5 2 8

3 Linear algebra for econometrics

A very useful matrix which has been used in econometrics is

1
M 0 = In − 1 × 10
n
where 1 is an n × 1 vector of ones. It can be used to transform data to deviations from their mean.

1
 a) Show that M 0 is symmetric idempotent.
Hint: it must satisfy (M 0 )0 M 0 = M 0 .
n
(xi − x̄)2 ), compute x0 (M 0 )0 M 0 x.
P
b) To obtain the sum squared deviations about the mean (
i=1

4 Potential exam question

Consider a matrix Am×n . Which of the following statements are true (in every case)? Which are false (in
at least one case)? Explain why.

1. If the rank of matrix A is smaller than m, A has full rank.

2. If m = n, A is a square matrix with full rank.

3. If we interchange the last two rows of matrix A, the determinant of A is not affected.

4. If there are k linearly independent rows in A, then k is the rank of A.

5 Systems of linear equations: application

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:

1. Calculate |A|.

2. Is A invertible? Justify briefly.

3. Calculate A−1 .

4. What is the optimal portfolio θ given b = (b1 ; b2 ; b3 )0?

2
6 System of equations: unique, several, no solutions
For a given system of equations
   
  

 x1 + x2 + x3 = 2q,  1 1 1  x1  2q 
2x1 − 3x2 + 2x3 = 4q, ⇔  2 −3 2   x2  =  4q ,
    
    
3x1 − 2x2 + px3 = q, 3 −2 p x3 q

| {z } |{z}
A B

answer the following questions:

1. For which values of the constants p and q does the system have a unique solution, several solutions or
no solution?

For exercises (b) and (c) assume that the rank of matrix A is equal to the size of vector x. In other words,
if x is n × 1, the rank of A has to be n. (This condition implies that (A0 A)−1 exists).

1. Show that if the solution of the system exists and is unique, then B is in the sub-space generated by
the column vectors of A (Hint: B can be rewritten as a linear combination of the column vectors of
A).

2. If the system admits no solution, it is possible to approximate the system by:

Ax = B − ,

where  is constructed in such a way that B is in the sub-space generated by the column vectors of A.
To be efficient, we want to minimize the norm of . What should we do and what is the final solution?
(You can provide a graphical intuition in parallel with your mathematical results).

7 Cramer’s Rule
Consider the following system of equations:

5P1 + P2 − P3 = 9
−2P1 + 5P2 − P3 = 3
−2P1 − 2P2 + 14P3 = 34

What is the vector P = (P1 , P2 , P3 ) that solves the system?

3
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 4: Linear algebra: systems of equations
Professor: Roxana Mihet
TAs: Elliot
Due Oct 14th

1. Systems of linear equations

For what values of the constant p and q does the following system have a unique solution, several solutions,
or no solution?

x1 + x2 + x3 = 2q
2x1 − 3x2 + 2x3 = 4q
3x1 − 2x2 + px3 = q.

2. Economy with 3 industries

Suppose that there is an economy with three industries: labor, transportation, and food.
Let $1 produced in the labor industry require 40 cents in transportation and 20 cents in food as inputs; while
$1 in transportation takes 50 cents in labor and 30 cents in transportation; finally, $1 in food production
uses 50 cents in labor, 5 cents in transportation, and 35 cents in food.
Let demand in the current production period be $10, 000 for labor, $20, 000 for transportation, and $10, 000
for food.
Find the production schedule for the economy.

3. Quadratic forms and definiteness

Determine the definiteness of

Q = 3x21 + x22 + 6x23 − 2x1 x2 + 2x1 x3 + 4x2 x3

4. Definiteness, decomposition, eigenvectors

Consider two following quadratic forms:

QID = x21 + x22 + x23 − 2x1 x2 − 2x1 x3 ,

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

1. Determine the definiteness of QID and Q.

2. Consider the corresponding matrix A of quadratic form Q (i.e. Q = xT Ax). Is it symmetric? Is it

invertible? Is it orthogonal?

3. Determine the eigenvalues of A. Recheck the definiteness of Q by using eigenvalue criteria.

1
 4. Find the eigenvectors that correspond to the eigenvalues of A.

5. Perform three different decomposition techniques on A that were introduced in class.

6. Calculate explicitly An as a function of n (Hint: use spectral decomposition of A).

5. Basis, subspaces
Let u1 = (3, 3, 4)0 and uk = (−1, −1, 5)0 be a basis for the subspace W of Rn .

1. Compose a matrix A using the u1 and u2 as the columns of A.

2. Construct a corresponding projection matrix P .

3. What is n in this problem? What is the dimension of W ?

   
1 1
4. Project vectors v = 2 and w = 1 onto a subspace described by P .
   

3 1

5. Compute the corresponding residual terms ev and ew .

6. Basis, null space

Let A be a matrix  
1 2 3
2 4 6
A=
 
−1

4 1
2 −8 −2
.

1. Find a basis for the null space of A, N ull(A).

2. Find a basis for the column space of A, Col(A).

3. Verify the Rank-Nullity Theorem (See the Lecture Notes).

7. Eigenvalues and eigenvectors

Consider        
−2 −1 4 1 1 1
A= 2 1 −2  , x1 =  0  , x2 =  −1  , x3 =  1  .
       

−1 −1 3 1 0 1

1. Verify that x1 , x2 and x3 are eigenvectors of A and find the corresponding eigenvalues.

2. Let
B = A · A.

Show that
B · x2 = x2

2
and
B · x3 = x3 .

Is it true that
B · x1 = x1 ?

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 Mathematics for Economics and Finance (Fall 2022)
Problem Set 5: Linear algebra, Calculus
Professor: Roxana Mihet
TAs: Madhushree A
Due Oct 21st

1 Spectral theorem
Let Q be the following quadratic form:

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

1. Write the quadratic form in matrix notation (i.e. Q = xT Ax) .

2. Compute the eigenvalues of matrix A. check the definiteness of Q using eigenvalues of A.

3. Compute the orthonormal eigenvectors of A.

4. Calculate explicitly An as a function of n (use spectral decomposition).

5. Compute the inverse matrix of A using spectral decomposition trick.

2 Matrix Decomposition
Let A be a symmetric matrix with  
2 1 −2
A= 1 2 −2
 

−2 −2 5
2
1. Show that the characteristic polynomial may be written in the form p (λ) = (λ − 1) (λ − 7).

2. Show that the vector equation Ax = x reduces to a single scalar equation. Find orthonormal eigenvec-
tors x, y corresponding to the eigenvalue λ = 1.

3. Find a normalized eigenvector corresponding to the eigenvalue λ = 7.

4. Find a diagonal matrix D and an orthogonal matrix S such that S −1 AS = D.

5. Find A−1 and define spectral decomposition.

3 Calculus in Euclidean Space

Consider the function f (x) = ln(x2 + x − 1). What are the support and the range of f ?

1
4 Concavity
Is a function f (x) = 1 − x2 concave? Is it strictly concave? Do the same properties still hold for a function
f (x, y) = 1 − x2 ?

5 Function continuity
a) Let f, g be two continuous functions on [a, b] ⊂ R and let x0 ∈ (a, b) with f (x0 ) = g(x0 ). We then
define 
f (x) if x ∈ [a, x ),
0
h(x) =
g(x) if x ∈ [x0 , b].

Verify that h is continuous on [a, b].

b) Verify that h is continuous on R, where h is given by


1 if x ∈ (−∞, −1),


h(x) = x2 if x ∈ [−1, 2),


x + 2 if x ∈ [2, ∞).


2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 6: Calculus
Professor: Roxana Mihet
TAs: Madhushree
Due Oct 28

1 Limits
Find the following limits
4n
1. lim ,
n→∞ n!

n2 +3n
2. lim 2 ,
n→∞ 2n +1

3. limx→0 x2 sin 1
.



x
q
4. lim 9x3 +5 .
x3 +7x
x→∞

2 Homothetic preferences
1
Suppose that in a two-commodity world, the consumer’s utility function takes the form u(x) = [α1 xρ1 + α2 xρ2 ] ρ , α1 +
α2 = 1 (CES).

1. Show that when ρ = 1, indifference curves become linear.

2. Show that as ρ → 0, this utility function comes to represent the same preferences as the (generalized)
Cobb-Douglas utility function u(x) = xα 1 α2
1 x2 .

3. Show that as ρ → −∞, indifference curves become “right angles”; that is, this utility function has in
the limit the indifference map of the Leontief utility function u(x1 , x2 ) = M in {x1 , x2 } .

3 Sandwich Theorem
Use the Sandwich theorem to prove that:
 
1
lim xcos =0 (1)
x→0 x

4 Sandwich theorem
Consider the function : (
1 + 2x2 if x is rational
f (x) =
1 + x4 if x is irrational

Use the Sandwich Theorem to prove that

lim f (x) = 1 .
x→0

1
5 Homogeneous functions
Is a linear production function homogeneous? Is it homothetic?

F (K; L) = αK + βL

where K denotes capital, L denotes labor, and α and β are strictly positive constants.

6 Homogeneous function
What is the degree of homogeneity of this function?

• f (x, y) = x2 + y 2

• f (x, y) = x4 + y 4 + 2

7 Bounded, closed, open

The set M ⊂ R2 has boundary points that do not belong to M . Which of the following statements are true
and which are false? Explain why.

1. M is open.

2. The set of points of the set M which are isolated is not empty.

3. M is unbounded.

4. There exists a limit point of the set M which does not belong to M .

8 Derivatives
Compute the derivatives:

1. y = sin 1+x
2x
2

√
2. y = ln(x + 1 + x2 )

q
(x−1)(x−2)
3. y = (x−3)(x−4)

9 Taylor expansion
Consider the function f (x) = ln(x2 + x − 1). Compute the exact value of f at x = 1.1 and compare it to
the third-order Taylor approximation in the neighborhood of x = 1. What is the order of the approximation
error?

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 7: Calculus
Professor: Roxana Mihet
TA: Madhushree
Due: Nov 4

1 Derivatives
Find the following derivatives:

1+x−x2
1. y(x) = 1−x+x2

2 Partial derivatives
Assume (
1
(x2 + y 2 ) sin x2 +y 2, x2 + y 2 =
6 0,
f (x, y) =
0, x2 + y 2 = 0,

1. Show that all first-order partials exist, and check whether they are continuous.

2. Check whether the above function is differentiable at (0, 0).

3 First and second order partial derivatives

Let f : R2 → R be
xy(x2 −y 2 )
(
x2 +y 2 if (x, y) 6= (0, 0),
f (x, y) =
0 if (x, y) = (0, 0).

1. Find the first and second order partial derivatives with respect to x and y.

2. Compute the total differential of f (x, y).

3. Compute the total derivative with respect to y.

4. Check whether all second-order partial derivatives are continuous.

4 Concavity using Hessian matrix

q
5
You are given the following function: f (x, y) = −2x4 − y(3 + 10x) − 2y 6 − 5y 2 , with x ≥ 12 .

1. Is this function concave, convex, strictly concave, strictly convex?

2. What can you say about quasi-concavity and quasi-convexity of this function (without performing
further calculations)?

3. What can you say about strict quasi-concavity and strict quasi-convexity of this function (without
performing further calculations)?

1
5 Quasi-concavity
Let

f (x) = x3 ,
g(y) = −y.

1. Check whether f , g are strictly concave/strictly convex, concave/convex, pseudo-concave/pseudo-

convex, quasi-concave/quasi-convex.

2. Show that f + g is neither quasi-concave nor quasi-convex.

3. Show that a pseudo-concave function can only achieve its global maximum at a zero gradient point.

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 9: Calculus and Probability
Professor: Roxana Mihet
TA: Samy
Due Nov 18

1 Integration
Compute the following integrals:
Re
1. x2 ln xdx
1
Z
2. cos (2x) e3x dx
Re√ R1 2
3. 1
ln x dx + 0
ex dx
R 3 R 2x
4. 2 x
(x + 2y) dydx
RπRπ sin x
5. 0 y x dxdy
Z √
sin x
6. √ dx;
x
Z
7. ex sin x dx.

2 Bounds of integration
Compute the following integrals and see what happens when you change the order of integration
Z 1Z 1
1. (1 − x2 − y 2 ) dx dy;
0 0
√
Z 1Z x y
e
2. dy dx.
0 x y

1
3 Probability
Let A and B be two independent events.

1) Show that Ac and B c are independent.

2) Show that Ac and B are independent.

3) Compute P(A | B)

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 10: Statistics and Probability
Professor: Roxana Mihet
TA: Madhushree
Due Nov 25

1 Random variable
Let’s assume the random variable Xt to be distributed as follows ∀t = 1...T :
(
1
2 if x = 1,
P[Xt = x] = 1
2 if x = −1.

Then we rewrite the sum of those independent random variables as:

t
X
Wt = Xi .
i=1

Compute the expectation and variance of the random variable WT .

2 Coin problem
There are exactly 64350 gold coins in a chest. One of them is drawn randomly and tossed 5 times. Each
time the outcome is "heads".

1. What is the probability of this event ?

2. Now it appears that one of the coins was counterfeit : it had "heads" on both sides. What is the
probability that the coin that was drawn and tossed initially was actually the counterfeit ?

3. Later on you learn that there were another 29 counterfeits among those in the chest, all of which had
"tails" on both sides. Recalculate the probability that the coin tossed was the one with "heads" on
both sides.

3 Probability events
For events A, B, C, C1 , C2 such that 0 < P (C) < 1 which of the following statements are true?

1. P (A) > P (B) =⇒ P (A ∩ C) > P (B ∩ C)

2. P (A |C ) = P (A) , P (B |C ) = P (B) , P (A) > P (B) =⇒ P (A ∩ C) > P (B ∩ C)

3. P (A |C ) ≥ P (B |C ) , P (A |C c ) ≥ P (B |C c ) =⇒ P (A) ≥ P (B)

4. 0 < P (Ci ) < 1, ∪2i=1 Ci = Ω, P (A |Ci ) ≥ P (B |Ci ) =⇒ P (A) ≥ P (B)

1
4 Probability measure
Given a complete probability space (Ω, F, P). Prove that the conditional probability defined by

P (A ∩ B)
P ( A| B) = ,
P (B)

with A, B ∈ F is a probability measure.

5 Dependent/Independent random variables

Consider the following random variables. The random pair (X, Y ) has the following joint distribution:

X
1 2 3
1 1 1
2 12 6 12
1 1
Y 3 6 0 6
1
4 0 3 0

Are X and Y dependent random variables? Explain your answer. What is the marginal distribution of X
and Y , respectively?

6 Statistics for finance

Standard quantitative models of the stock market assume that stock returns follow a log-normal distribution.
If log X ∼ N (µ, σ 2 ), 0 < X < ∞, −∞ < µ < ∞, σ 2 > 0.

1. Find the pdf for X.

2. Compute E[X] and V[X].

7 MGF
2
1
u2 )
1. Verify that the MGF of a N (µ, σ 2 ) is ΦX (u) = e(uµ+ 2 σ .

2. Compute E[X] and V[X] using the MGF of N (µ, σ 2 ).

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 11: Statistics and Probability
Professor: Roxana Mihet
TA: Madhushree
Due Dec 2nd

1 Probability for finance: VaR

The Value-at-Risk (VaR) at probability α of a portfolio is defined as the minimum potential loss that the
portfolio may suffer in the α% worst cases, over a given time horizon.
Let the time horizon be one month. Then making an assumption on the distribution of portfolio returns, an
investor may determine that he has a 5% one month VaR of $x. This means that there is a 5% chance that
the investor could lose more than $x in any given month. Therefore, a $x loss should be expected to occur
once every 20 months.
Rb
Let a pdf (t)dt = 0.05. Find x and illustrate the case if
"
λe−λt t > 0,
1. a = −∞, b = x, pdf (t) =
0 t < 0,
t 2
2. a = −∞, b = x, pdf (t) = √1 e− 2σ2 ,
σ 2π
"
λe−λt t > 0,
3. a = x, b = ∞, pdf (t) = (How would you interpret the “positive” VaR?)
0 t < 0,
t 2
4. a = x, b = ∞, pdf (t) = √1 e− 2σ2 .
σ 2π

2 Mean and variance of a discrete and continuous random variable

Suppose that the random variable Z has cdf



 0 if z < 0

1

if z = 0
2
FZ (z) =


 (z + 1) /2 if 0 < z ≤ 1


1 if z > 1.


Is Z a discrete or continuous random variable? Calculate the mean and variance of Z.

3 Moments from PDF function

2
Consider the pdf defined by fX (x) = x3 , x > 1 and zero elsewhere.

1. Show that pdf is correctly defined.

2. Find E(X) and V ar(X).

1
4 True or false?
You have two random variables, X and Y . Consider three statements:
A = ‘The expectation of the product of X and Y is equal to zero. That is, E[XY ] = 0.’
B = ‘The correlation between X and Y is zero.’
C = ‘X and Y are independent.’
For the following statements, state whether they are true or false and explain why:

1. ¬B =⇒ ¬A

2. A =⇒ B

3. C =⇒ B

4. C =⇒ (A ∧ B), where ∧ means a logical “and”.

5 Conditional, Joint and Marginal Densities

Consider the following conditional density for Y given X = x is

2y + 4x
f Y |X ( y| x) = .
1 + 4x

The marginal density of x is

1 + 4x
fX (x) = ,
3
for 0 < x < 1 and 0 < y < 1. Find

1. the joint density fXY (x, y),

2. the marginal density of Y , fY (y), and

3. the conditional density for X given Y = y, f X|Y ( x| y).

6 Conditional Moments


For random variables X, Y ∼ N 0, σ 2 determine


1. E X X 2

2. E (X |XY )


3. E X + Y |X 2 + Y 2 .

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 12: Statistics and Static Optimization
Professor: Roxana Mihet
TA: Samy
Due Dec 9

1 Cramer-Rao Lower Bound

Consider logistic distribution which is heavily used in demographics and economics.
e−x+θ π2
Its density function is f (x; θ) = (1+e −x+θ )2 , x ∈ R, and EX = θ, V arX = 3 . Consider the following

estimator of θ: θb = X.

1. Show that it is unbiased and consistent.

2. Show that it is not EFFICIENT estimator of θ. Hint: compute the Cramer-Rao lower bound.

2 Unbiased estimator
Let X1 , ..., Xn be i.i.d N (µ, σ 2 ).

1. Show the statistics sample variance S 2 is unbiased estimator for σ 2 .

(n−1)S 2
2. Compute MSE of the estimator. (hints: σ2 ∼ χ2n−1 and Varχ2n−1 = 2(n − 1).)
n−1 2
3. An alternative estimator for σ 2 is the maximum likelihood estimator σ̂ 2 , show σ̂ 2 = n S .

4. Is σ̂ 2 a biased estimator? What is the variance of σ̂ 2 ? (e) Show that σ̂ 2 has smaller MSE than
S 2 .Explain why.

3 Markov Chains
Let πij = Pr(z 0 = zj |z = zi ) be the transition probability of an economic system to move to state zj if the
previous state was zi . The stochastic process z forms a Markov chain. Consider the matrix:
" #
π11 π12
Π= .
π21 π22

1. Under what conditions does Π constitute a transition probability matrix?

2. Assume the probability distribution over the states today is pt = (pt1 , pt2 ). What is the probability
distribution over the state in period t + 1 and t + 2, respectively?

3. Is z a Markov process? Show.

4. A stationary distribution is a vector (q, 1 − q) with 0 ≤ q ≤ 1 such that the probability distribution
over the state in period t + 1 equals the probability distribution over the state in period t. Show that
q solves (2 − π22 − π11 )q = (1 − π22 ).

1
4 Fisher Information Matrix
X1 , ..., Xn is a sample from a normal distribution with mean θ1 and variance 1, Y1 , ..., Yn is a sample from a
normal distribution with mean θ2 and variance 2 and Z1 , ..., Zn is a sample from a normal distribution with
mean θ1 + θ2 and variance 4. All three samples are independent.

1. Find the maximum likelihood estimators of θ1 and θ2 .

2. Find the Fisher Information Matrix.

3. Use it to find the asymptotic distribution of the MLEs.

5 Static optimization: Oil exploration

(Final Exam 2012) Consider the exploration company Dig Deep (DD). DD requires fresh capital to fund a
new exploration project in the Gulf region. For this purpose, DD approaches the investment bank Big Bank
(BB) for financing. BB is happy to help but requires compensation for providing capital.
If DD can secure financing, the expected net present value to DD, N P VDD , of the exploration project is
V minus the underwriting fees paid to BB, X. BB, in turn, earns an expected net present value, N P VBB ,
equal to the fees. BB incurs no costs.
DD and BB now negotiate over how to split the surplus. They decide to play a Nash bargaining game.
The bargaining power of DD is α ∈ [0, 1] and the bargaining power of BB is 1 − α. The equilibrium in the
game is determined by maximizing the generalized Nash product S, where

S = [N P VDD ]α · [N P VBB ]1−α .

1. State the optimization problem formally. What are the natural constraints on X implied by the
participation constraints?

2. What is the equilibrium fee X ∗ charged by BB? How does it depend on α? Interpret.

3. What are the expected net present values N P VDD and, respectively, N P VBB ? How do they depend
on α? Interpret.

You are an analyst at BB in the credit risk department. One day, your supervisor asks you to analyze
the profitabilities of all the projects that BB has financed during the last year. For simplicity, assume the
bargaining power of BB last year was 50%. For the purpose of your empirical study, you are given a sample
∗
of past fees, Xsample ∗
= (X1∗ , X2∗ , X3∗ , ..., XN ), on N deals. You decide to fit the fees to an exponential
distribution.

4. If X ∗ ∼ Exp(λ) has an exponential distribution with mean λ, what is the distribution of the project
values V given your assumptions above and the Nash solution?

5. Compute by using direct computations, the two first central moments of the random variables X ∗ and
V.

6. Find the maximum likelihood estimator for λ.

7. What is the expected project value, E[V ], and what is the variance of the project values, V ar[V ], given
∗
the sample Xsample ?

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 13: Optimization
Professor: Roxana Mihet
TA: Samy
Due Dec 16

1 Optimization
Consider the function f defined for all (x, y) by

f (x, y) = (1 + y)3 x2 + y 2 .

Prove that f has a unique stationary point at (0, 0) which is a local minimum, but f has no global minimum.

2 Constrained Optimization on General Convex Sets

Consider the optimization problem
max f (x; θ)
x∈X(θ)

where f is a real-valued C 1 function, θ ∈ Θ is a parameter vector, and X(θ) is a closed, convex subset of RN
for all θ. Denote the gradient by Df (x; θ). Determine whether the following statements are true or false:

1. If Df (x∗ ; θ) = 0, then x∗ is a local extremum.

2. If x∗ is a local extremum, then Df (x∗ ; θ) = 0.

3. If Df (x∗ ; θ) 6= 0, then x∗ is not a local extremum.

4. If x∗ is a local extremum and f is strictly quasi-concave, then x∗ is a global extremum.

5. If f is strictly concave on X × Θ, then the value function is strictly concave.

3 Cobb-Douglas production
Consider a competitive firm that produces a single output y using two inputs x1 and x2 . The firm’s
production technology is described by a Cobb-Douglas function

β
y(x) = f (x1 , x2 ) = xα
1 x2 ,

where α + β < 1, α > 0 and β > 0. Taking as given the output price p and the input prices w1 and w2 , the
firm maximizes its profits given by
Π(x) = py(x) − wT x.

1. Does the production function exhibit decreasing, constant, or increasing returns to scale? Show.

2. Write the first-order conditions and check whether sufficient conditions for a maximum are satisfied.

3. Solve for the firm’s factor demands, giving the optimal input levels x∗i as functions of input and output
prices.

1
4 Cobb-Douglas utility function
1−α
Assume the consumer’s utility function is Cobb-Douglas utility function: u(x1 , x2 ) = kxα
1 x2 for some
α ∈ (0, 1) and k > 0,and his budget constraint follows: p1 x1 + p2 x2 = w. Find the consumer’s optimal
consumption bundle.

5 The Kuhn-Tucker Method: Optimization Under Inequality Con-

straints (Final Exam 2015/2016)
A social planner is faced with the following optimization problem:

max f (x, y, z) = 2x + y + az,

(x,y,z)∈D

where
D = {(x, y, z) ∈ R3 | x2 + ay 2 ≤ a, x2 + az 2 ≤ a, a > 0}.

1. Explain why f must have a maximum on D.

2. For which points (x, y, z) and parameter a does constraint qualification hold?

3. Formulate the necessary conditions for the maxima of f on D.

4. Find the optimum.

5. What is the value of a if the value of z at optimum is √1 .

2

6. Without computations, what can you say about the solution of the optimization problem if:

(a) D = {(x, y, z) ∈ R3 | x2 + ay 2 ≥ a, x2 + az 2 ≤ a, a > 0}.

(b) You minimize f (x, y, z).

2
 Mathematics for Economics and Finance (Fall 2022)
Problem Set 14: Statistics and Static Optimization
Professor: Roxana Mihet
TA: Samy
Due Dec 23

1 Unconstrained optimization on open set

Show that the function f (x1 , x2 , x3 ) = x21 + x22 + 3x23 − x1 x2 + 2x1 x3 + x2 x3 defined on R3 has only one
stationary point and it is a local minimum.

2 The Langrange Method: Optimization under Equality Constraints

Consider an economy with 100 units of labor. It can produce chocolates x or watches y. To produce x
chocolates, it takes x2 units of labor, likewise y 2 units of labor are needed to produce y units of watches.
Economy has the following objective function F (x, y) = ax + by. Solve for the optimal amounts of x and y.

3 Complements or substitutes?
An agent consumes two goods, x1 and x2 , with prices p1 and p2 ,respectively. Her utility function is of the
form U (x1 , x2 ) = α(xα α
1 + x2 ), with α < 1. Verify that utility function is strictly concave. Derive the demand
function of the agent. In what direction does the demand for good 1 change if there is an increase in the
price of good 2.

4 Kuhn-Tucker Theorem again

An agent consumes two commodities. Her utility function is

u(x1 , x2 ) = x21 + 2x2 ,

where x1 indicates her expenditure on good 1 and x2 here expenditure on good 2. The prices for the
commodities are p1 and p2 respectively, both positive. And the consumer can not spend more than her
income I, also a positive value.

1. Assuming that consumption of either commodities must be non-negative, formulate the utilization
maximization problem of this consumer.

2. Explain carefully why this maximization problem has a solution.

3. Show that all conditions required in Kuhn-Tucker’s Theorem are satisfied.

4. Suppose p1 = 2, p2 = 1, and I = 6. Using Kuhn-Tucker’s Theorem, or otherwise, find the pair (x1 , x2 )
that maximizes the consumer’s utility.

1
5 Dynamic programming: Minimizing quadratic costs
The agent solves
∞
X
β t x2t + vt2


min
{vt }
t=0

s.t. xt+1 = 2xt + vt , x0 is given, 0 < β < 1.

6 Dynamic programming question on Final Exam

Consider an economy where the utility of the representative agent is given by
∞
X
β t u(Ct , Lt ), β ∈ (0, 1),
t=0

where Ct is the consumption and Lt the leisure in period t. Assume that the representative agent has the
following instantaneous utility function

L1−γ
t
u(Ct , Lt ) = ln(Ct ) + θ .
1−γ

Denote output by Yt , capital by Kt , and the number of hours worked by Ht . The production function is
given by:
Yt = AKtα Ht1−α , (1)

where A is a constant productivity parameter. The total available time in each period is normalized to 1.
So, Ht + Lt = 1. The law of motion of capital is

Kt+1 = (1 − δ)Kt + It (2)

where δ ∈ (0, 1) is the depreciation rate and It denotes investment in period t. K0 is given. The resource
constraint in period t is given by Yt = Ct + It . We want to find the optimal paths of the choice variables for
t = 0, 1, ..., ∞.

1. Explain Bellman’s Principle of Optimality.

2. List all choice variables and the required state variables in this problem.

3. Write down the Bellman equation in terms of H and K.

4. Derive the necessary first order conditions and the intertemporal Euler equation expressing the marginal
rate of substitution in terms of Yt+1 and Kt+1 .