ASSIGNMENTS, PART 1

GRA6039 FALL 2015

STEFFEN GRNNEBERG

Assignment 1. Please do the following assignments from Chapter 2 in Stock

& Watson: Exercises 8, 10 and 25
Assignment 2. In the lecture, we claimed that when a < b, we have
P(a < X b) = P(X b) P(X a).

(1)

Let us show why this is so.

(A) Let
A = {X a},

B = {a < X b}.

Why are A and B disjoint?

(B) Argue that
A B = {X b}.
(C) The fundamental structure of probability is as follows.
(I) Probability involves a set of potential outcomes of an experiment
1 , 2 , . . .. All possible outcomes are gathered in .
(II) Collections of outcomes A are given probabilities 0 P(A)
100% = 1, with P() = 1, P() = 0.
(III) If A and B share no common elements (they are disjoint, and hence
A B = ), then P(A B) = P(A) + P(B)
(IV) If A1 , A2 , A3 , . . . are all disjoint subsets of (so that Ai Aj =
unless i = j), then
!

[
X
P
Ai =
P(Ai ).
i=1

i=1

Use this to conclude with eq. (1).

Assignment 3. We will now prove the validity of the equality
E(aX + bY + c) = aE(X) + bE(Y) + c.
(A) Suppose given a function g(x) and a random variable X with density f1 (x).
The expectation of the random variable Z = g(X) is
Z
EZ =
g(x)f1 (x) dx.

Use this to show that

E(aX + b) = aE(X) + b
Hint: Set g(x) = ax + b.
Date: August 21, 2015.
1

STEFFEN GRNNEBERG

(B) Suppose given another random variable Y, with marginal density f2 (x).
Denote the joint density of X and Y by f1,2 (x, y). Recall that for functions
h, we have that
Z Z
h(x, y)f1,2 (x, y) dx dy.
Eh(X, Y) =

Use this to show that

E(aX + bY + c) = aE(X) + bE(Y) + c.
R
Hint: Recall that in Lecture 1, we showed that f1,2 (z1 , x2 ) dz1 =
f2 (x2 ). Also recall that
Z Z
f1,2 (z1 , z2 ) dz2 dz1 = P(X1 < , X2 < ) = 1.

Assignment 4.
and Y is

Recall that the covariance between two random variables X

Cov (X, Y) = E[(X EX)(Y EY)].

The covariance is the average value of the product of the deviation of X from its
mean and the deviation of Y from its mean. If the random variables are positively
associated that is, when X is larger than its mean, Y tends to be larger than
its mean as well the covariance will be positive. If the association is negative
that is, when X is larger than its mean, Y tends to be smaller than its mean the
covariance is negative.
(A) Show that we can also write
Cov (X, Y) = (EXY) (EX)(EY).
and that
Cov (X, X) = Var X.
(B) Let A = a + X and B = b + Y. Show that Cov (A, B) = Cov (X, Y). Hence,
the covariance between variables does not change when adding constants to
them.
(C) Now let A = a + cX and B = b + dY. Show that Cov (A, B) = cd Cov (X, Y),
that is, that
Cov (cX + a, dY + b) = cd Cov (X, Y).
Assignment 5. Please do Assignment 6 in the final GRA6039-exam given in
2012.
Voluntary assignments (that will not show up on the final exam)
Assignment 6. The Cauchy-Schwartz inequality (also known as the CauchyBunyakovskii inequality in Russian-speaking countries) is that when X and Y are
random variables, we have that
q
q
E(|XY|) E(|X|2 ) E(|Y|2 ).
This extremely important inequality is proved on page 733 in Stock & Watson, but
we will here provide another proof.
(A) Consider the second degree equation
p(t) = at2 + bt + c.

ASSIGNMENTS, PART 1

GRA6039 FALL 2015

Suppose p(t) 0 for all t. Show that this implies that

b2 4ac.
(B) Consider the positive function


p(t) = E (|X| + t|Y|)2 .
Show that the previous point implies the Cauchy-Schwartz inequality.
Assignment 7. ... But should we really need to care about finite
means in the Law of Large Numbers?
In the paper Lvy Processes From Probability to Finance and Quantum
Groups (uploaded on Itslearning) David Applebaum writes
A sociologist investigating the behavior of the probability community during the early 1990s would surely report an interesting phenomenon. Many of the best minds of this (or any other) generation
began concentrating their research in the area of mathematical finance. The main reason for this can be summed up in two words
option pricing.
The key question is does the market determine a unique price
for a given option, and if so, can this price be explicitly computed?
Much of the current interest in the subject derives from Nobel prize
winning work of F. Black, M. Scholes and R. Merton in the 1970s
who gave a positive answer to this question. Underlying their analysis was a model of stock prices that improved upon that of Bachelier
by using geometric Brownian motion.
...
Although very elegant, the Black-Scholes-Merton model has limitations and possible defects that have led many probabilists to query
it. Indeed, empirical studies of stock prices have found evidence of
heavy tails, which is incompatible with a Gaussian model, and this
suggests that it might be fruitful to replace Brownian motion with
a more general Lvy process.
Applebaum claims that the discoveries in mathematical finance has surpassed
the glory of any generation surely to seduce mathematicians into studying financial problems. While the mathematics behind these types of stochastic processes is
indeed quite complex, this crude overstatement would probably amuse the sociologists.
Obviously, we will not study such stochastic processes in this course. However,
let us get a very brief taste of the quirks of Lvy-processes. Figure 1 displays the
realization of a so-called Cauchy-process, which is a Lvy-process.
(A) At each specific time, the location of a Cauchy-process has the Cauchydistribution (named after the very same Cauchy as in the Cauchy-Schwarz
inequality). Its density is given by


1
1
,
f(x) =
1 + x2
and has much heavier tails than the Normal distribution. The Cauchy
density is plotted together with the standard Normal distribution in Figure
2.

STEFFEN GRNNEBERG

Figure 1. A simulation of a Cauchyprocess

Figure 2. Cauchy and Normal densities

In fact, a Cauchy-distributed random variable has so heavy tails that it
does not even have an expectation, despite having a density that is symmetric around zero (and this symmetry does imply that their median, which
always exists, is zero).
Hence, the expected location of a Cauchy-process is undefined. For technical reasons, the existence of the expectation of a random variable X is
equivalent to the existence of the expectation of the absolute value of the
variable. If
Z

E|X| =

|x|f(x) dx = ,

ASSIGNMENTS, PART 1

GRA6039 FALL 2015

the expectation EX does not exist. Show that the Cauchy-distribution indeed does not have a finite mean.
(B) Heavy-tailed distributions are of practical use in finance. However, distributions usually have at least second order moments, that is, EX2 exists.
This implies that the first-order moment EX also exists. Use the Cauchy
Schwartz inequality to prove that if EX2 is finite, then E|X| is also finite
(and hence EX exists).
Hint: Use that X = 1 X.
(C) An important extension of the CauchySchwartz inequality is the Hlder
inequality, stated in terms of two positive numbers p and q for which
1
1
+ = 1.
p q
The inequality is given by
E(|XY|) (E [|X|p ])

1/p

(E [|Y|q ])

1/q

Prove that the existence of a certain higher-order moment, say > 0,

implies the existence of all lower-order moments using the Hlder inequality.
(D) An amusing property of Cauchy-distributed random variables is the following. Suppose X1 , X2 , . . . , Xn are IID Cauchy-distributed. Then one can
n is also Cauchy-distributed. Why does this mean
show that their mean X
that the law of large numbers does not apply to Cauchy-distributed random
variables?
Hint: Use the definition of convergence in probability.
Department of Economics, BI Norwegian School of Management, Nydalsveien 37,
Oslo, Norway 0484, Norway
E-mail address: Steffen.Gronneberg@bi.no