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Mathematics for Economics and Finance

Midterm Exam
Answer Key
Instructor: Norman Schürho¤

Question 1 (10 points)


You have just …nished 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
…rst 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 payo¤s of the three types of securities in three possible
scenarios are 2 3
2 1 1
A=4 2 3 2 5;
2 2 3
where each column is a di¤erent asset, and each row is a di¤erent scenario.
Your goal is to determine the portfolio allocation in each asset class, denoted 2 R3 , given
the client’s target payo¤ b 2 R3 in each scenario. In other words, you want to determine
such that A = b. To make sure that this is feasible, you determine the following:
a) Calculate jAj.
b) Is A invertible? Justify brie‡y.
c) Calculate A 1 .
d) What is the optimal portfolio given b = (b1 ; b2 ; b3 )0 ?

Answer to Question 1
a) det(A) = 10:
b) Yes, since det(A) = 10 6= 0.
c) 0 1
1 1 1
2 2 2
A 1
=@ 1
5
2
5
1
5
A
1 3 4
5 5 5

d) A = b ) = A 1b )
1 1 1
1 = b1 + b2 b3
2 2 2
1 2 1
2 = b1 b2 + b3
5 5 5
1 3 4
3 = b1 b2 + b3
5 5 5

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Question 2 (10 points)
For each of the following questions, either provide a function and show brie‡y that it satis…es
the required conditions, or show why you cannot …nd 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?

Answer to Question 2
a) Yes, take for example f (x) = x3 . f (x) is continuous, is de…ned in R, but attains neither
its maximum (+1) nor its minimum ( 1).
b) Yes, take for example X = R++ and

1 if x is rational,
f (x) =
0 otherwise.

f (x) is discontinuous everywhere, yet it attains its maximum 1 and its minimum 0, and
it is de…ned over the open and unbounded interval (0; 1).
c) No. A continuous function f de…ned over a closed and bounded set X R attains, by
Weierstrass’Theorem, both its maximum and its minimum.

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Question 3 (10 points)
Determine whether the following statements are true or false (by “false” I mean not neces-
sarily true). In each case, brie‡y 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.

Answer to Question 3
a) True. By the complementary slackness conditions: j (gj (x) bj ) = 0; 8j = 1; :::; m. If
we have j > 0, then gj (x) bj = 0 must be true.
b) False. The constraint could be “just”binding. In this case the marginal value of relaxing
the constraint is zero, i.e., j = 0. The complementary slackness conditions still hold in this
case, since both j = 0 and gj (x) bj = 0.
c) True. By the complementary slackness conditions: j (gj (x) bj ) = 0; 8j = 1; :::; m. If
gj (x) bj 6= 0; then j = 0 must be true.
d) False. The constraint could be “just”binding. In this case the marginal value of relaxing
the constraint is zero, i.e., j = 0. The complementary slackness conditions still hold in this
case, since both j = 0 and gj (x) bj = 0.

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Question 4 (15 points)
This is your …rst 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 …rm’s production function Y =
f (K; L) = K 1=2 L1=2 with K =Capital, L =Labor, the …rm’s cost function is C(Y ; r; w) =
minK;L frK + wL subject to K 1=2 L1=2 = Y g. Note that r is the cost of capital that the chief
…nancial o¢ cer 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 …nancial o¢ cer (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 …rm 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 su¢ cient workers.
e) How do the cost depend on the factor prices? That is, …nd @C@r
(1; 1; 1) and @C
@w
(1; 1; 1).

Answer to Question 4
The minimum cost function (i.e., the value function of the cost minimization problem) is
de…ned by
C(w; r; Y ) = min wL + rK : KL = Y 2 :
K;L

a) Solving for L(w; r; Y ) and K(w; r; Y ), using Lagrange’s method, one obtains
1=2
rY 2
L(w; r; Y ) = ;
w
1=2
wY 2
K(w; r; Y ) = :
r
b) Replace these into the cost function to get the minimum cost function,

C(w; r; Y ) = 2(wr)1=2 Y:

This function evaluated at (w; r; Y ) = (1; 1; 1) yields

C(1; 1; 1) = 2(1)1=2 1 = 2:

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@C @C
c) First, obtain @Y
= CY (w; r; Y ) = 2(wr)1=2 , and evaluate it at (1; 1; 1) to get@Y
(1; 1; 1) = 2:
1=2 1=2
d) The input demand functions are L (w; r; 1) = wr , K (w; r; 1) = w
r
. Let (w; r) =
(1; 1), then L h(1; 1; 1) = K (w;
i r; 1) = 1. We can rewrite these functions as f : R2++ ! R2++ ,
1=2 1=2
f : (w; r) ! wr ; wr . Note that the function f is well de…ned for positive factor
prices, r > 0; w > 0, and it is continuous and di¤erentiable in a neighborhood of (1; 1).
1=2 1=2
e) Obtain @C @r
= wr Y > 0 and @C@w
= wr Y > 0. Note that the minimum cost
function is increasing in both factor prices. Evaluate it at (1; 1; 1) to get @C
@r
(1; 1; 1) = 1,
@C
@w
(1; 1; 1) = 1.

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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
…nance classes at HEC that stock returns can have di¤erent volatility. That means, they
are heteroskedastic. So you consider the following generalized least squares problem. Let

y=X +

where

E( ) = 0;
E( 0 ) = 2 ;

and E( ) is the expectation operator. In other words, is heteroskedastic with variance-


covariance matrix 2 (i.e., is a positive de…nite symmetric matrix).
The problem is you cannot …nd your econometrics book which would tell you what the
generalized least squares estimator of is. To solve the problem of …nding an estimator for
yourself, you take three steps. First, you de…ne the standardized error term

P :

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


a) Apply a Matrix Decomposition Theorem to …nd a matrix P such that
0 2
E( )= I:

That means you try to …nd 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 . (Hint: You have derived a
least-squares estimator of in the exercise sessions of your mathematics course at HEC.)

Answer to Question 5
We have
0
E( ) = E(P (P )0 )
= E(P 0 P 0 )
= P E( 0 )P 0
= 2P P 0:

Hence, E( 0 ) = 2 I if and only if P P 0 = I.


Let the spectral decomposition of be = C C 0 , with
0 1
1 0
B .. C ;
C= c1 c2 cn , = @ ... ...
. A
0 n

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where fci gi=1;:::;n: are the eigenvectors and f i gi=1;:::;n: are the eigenvalues.
De…ne
1
0
P 2C :

1 1 1 1 1 1
Then P P 0 = C 0 ( 2 C 0 )0 =
2 2C
0
C 2 = 2C 0C C 0C 2 = I since C 0 C = I.
1 1
Also, P 0 P = ( 0
2C )
0 0
2C = C
1
C = ((C 0 )
0 1
C 1 1
) = (C C 0 ) 1
= 1
.
Now,

y = X +
, Py = PX + P
, y =X +

with y P y, X P X, P and E( 0 ) = 2 I.
This is now a standard OLS problem, for which we already know the solution

= (X 0 X ) 1 X 0 y
= ((P X)0 P X) 1 (P X)0 P y
= (X 0 P 0 P X) 1 X 0 P 0 P y
= (X 0 1 X) 1 X 0 1 y: