Mathematics for Economics and Finance (Fall 2023)

Problem Set 11 Solutions: Probability & Statistics

Professor: Norman Schürhoff
You do not need to hand in any solutions!
8 December 2023

1 Markov chain, transition probability

Let πij = Pr(z ′ = 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 ).

Answer: Markov chains:

P2
1. 0 ≤ πij ≤ 1, j=1 πij = 1.

2. pt+k = pt Πk .
3. E[z t+1 |z t = zi , z t−1 , ...z 0 ] = z1 πi1 + z2 πi2 = E[z t+1 |z t = zi ].

4. (q; 1 − q) = (q; 1 − q)Π = (qπ11 + (1 − q)(1 − π22 ), q(1 − π11 ) + (1 − q)π22 ) ⇔ q = qπ11 + (1 − q)(1 − π22 )
and 1 − q = q(1 − π11 ) + (1 − q)π22 ⇔ q(2 − π22 − π11 ) = (1 − π22 ).

2 Local and global extrema, stationary points

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.

Answer: FOC:
∂f
= 2(1 + y)3 x = 0, (1)
∂x
∂f
= 3x2 (1 + y)2 + 2y = 0. (2)
∂y

From (1) ⇒ x = 0 or y = −1. If x = 0, then from (2) ⇒ y = 0. If y = −1, from (2) derive contradiction.
⇒ Only (0, 0) is stationary point.

1
 ′′ ′′ ′′ ′′
Check Hessian, f11 = 2(1 + y)3 , f22 = 6x2 (1 + y) + 2, f12 = f21 = 6x(1 + y)2 . At point (0, 0),
 
2 0
H=
0 2

⇒ D1 = 2, D2 = 4 > 0, Positive definite ⇒it is local minimum.

But it is not a global minimum, for example: f (x, −2) = −x2 + 4, if x → ∞, then f (x, −2) → −∞.

3 Static optimization
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 ?

Answer:
1.

max S = (V − X)α X 1−α

X
s.t. X < V

2
2. FOC:

−α(V − X)(α−1) X 1−α + (V − X)α (1 − α)X −α = 0

⇒ (V − X)α (1 − α)X −α = α(V − X)(α−1) X 1−α

⇒ X ∗ = (1 − α)V

The fees charged by the bank is increasing with the bank’s bargaining power (1 − α).

3. For the bank sic previous answer, for the exploration company the NPV at equilibrium = V −X ∗ = αV
and so is decreasing with the bargaining power of the bank.
4. Because the distribution of X ∗ is an exponential distribution with parameter λ, the distribution of
(1 − α)V follows also an exponential distribution with parameter λ.
∗ ∗
5. First for E[V ] at equilibrium: V = 1−αX
, so if we set du = λe−λX dX ∗ and v = X ∗ , we get dv = dX ∗
−λX ∗
and u = −e and it follows that:
Z ∞ i∞ Z ∞
1 ∗ −λX ∗ ∗ 1 h ∗ −λX ∗ ∗
E[V ] = X λe dX = ( −X e + e−λX dX ∗ )
1−α 0 1−α 0 0
 ∞
1 1 −λX ∗ 1 1
= ( − e )=
1−α λ 0 1−αλ

We look now for V ar(V ) = 1

(1−α)2 V ar(X ∗ ). We want to compute V ar(X ∗ ). We need to compute
E[X ∗ 2 ], this time we set du = λe −λx
dx and v = x2 , get dv = 2xdx and u = −e−λx . This leads to:
Z ∞
∞
E[X ∗ 2 ] = −x2 e−λx 0 + 2xe−λx dx

0
2 ∞
Z
2 2
= xλe−λx dx = m1 = 2
λ 0 λ λ

2
Now we eventually get V ar(X ∗ ) = m2 − (m1 ) = 1
λ2 and V ar(V ) = 1
((1−α)λ)2

6. Here the constant (1 − α) does not play any role: The MLE is defined by
λ̂M L = arg max L(λ |X ∗ )
λ

or equivalently λ̂M L = arg max ln L(λ |X ∗ )

λ
We first define the likelihood function L(λ |X ∗ ) by
n
n Xi∗
P
−λ
∗ −λXi∗ n
Q
L(λ |X ) = λe =λ e i=1

i=1
We then compute the log-likelihood function
n !
Xi∗ n
P
−λ
ln L(λ |X ∗ ) = ln λn e Xi∗
P
i=1 = n ln λ − λ
i=1

The first-order condition for the maximum likelihood estimation is

FOC:

∂
∂λ ln L(λ̂M L |X ∗ ) = 0

3
 n
n
Xi∗
P
λ̂M L
− =0
i=1
n 1
λ̂M L = Pn = X¯∗
Xi∗
i=1

7. Using the ML estimator for λ we can rewrite the two first central moments of X ∗ as follows:
E [X ∗ ] = X¯∗
2
V [X ∗ ] = X¯∗

X¯∗ X¯∗ 2 2
Then we find E[V ] = 1−α = 2X¯∗ and V ar(V ) = (1−α)2 = 4X¯∗

4 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) ̸= 0, then x∗ is not a local extremum.
4. If x∗ is a local extremum and f is quasi-concave, then x∗ is a global extremum.

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

Answer:

1. False. If Df (x∗ ; θ) = 0, then x∗ may be an inflection point.

2. False. If x∗ is a local extremum, then x∗ may be a corner solution at which Df (x∗ ; θ) ̸= 0.
3. False. If Df (x∗ ; θ) ̸= 0, then x∗ may be a corner solution yet still a local extremum.

4. True. We want to show that if f is quasi-concave and x∗ is a local max then x∗ is a global max. Let’s
proof by contraposition: assume f is quasi-concave, x∗ is a local max but not a global max ⇒ there
exists x′ ∈ X(θ) and x′ ̸= x∗ such that f (x′ ) > f (x∗ ). By convexity of X(θ) : (x′ − x∗ ) is a feasible
direction from x∗ . By quasi-concavity of f : f (x′ ) > f (x∗ ) ⇒ Df (x∗ )(x′ − x∗ ) >= 0. (∗) 2 cases are
possible:

(a) Df (x∗ ) = 0. From (∗) we have f (x′ ) > f (x∗ ) implies Df (x∗ )(x′ − x∗ ) = 0 and therefore x∗ is an
inflexion point.
(b) Df (x∗ ) ̸= 0. From (∗) we have f (x′ ) > f (x∗ ) implies Df (x∗ )(x′ − x∗ ) > 0 and therefore x∗
cannot be a local max since the necessary condition for a local max is that Df (x∗ )(x′ − x∗ ) <= 0.

Thus, if f is quasi-concave, x∗ is not a global max implies x∗ is not a local max. So, we arrive to a
contradiction.
5. True. If f is strictly concave on X × Θ, then the value function is strictly concave. The value function
inherits this properties from the objective function.