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Essential Linear Algebra for Finance
This chapter aims to equip readers with the tools of matrix algebra that are applied in
finance. Starting with basic definitions and notation, we provide a detailed understanding of
matrix algebra and its important financial applications. An understanding of matrix algebra
is necessary for modelling all types of portfolios. Matrices are used to represent the risk and
return on a linear portfolio as a function of the portfolio weights and the returns and covari-
ances of the risk factor returns. Examples include bond portfolios, whose value is expressed
as a discounted cash flow with market interest rates as risk factors, and stock portfolios,
where returns are represented by linear factor models. Matrices are used to represent the
formulae for parameter estimates in any multiple linear regressions and to approximate the
returns or changes in price of non-linear portfolios that have several risk factors.
Without the use of matrices the analysis becomes extremely cumbersome. For instance,
it is easy to use matrices to solve a set of simultaneous equations in many variables, such
as the linear equations that arise when a trader hedges an options portfolio against changes
in its risk factors. The covariance matrix and the Cholesky decomposition of this matrix
lie at the heart of financial analysis: they are used to simulate correlated returns and to
measure portfolio risk. In highly correlated systems, such as returns on futures contracts on
the same underlying but with different expiry date, we use the eigenvalues and eigenvectors
of a matrix to identify the most important sources of variability in the system. Eigenvalues
and eigenvectors are also used to ensure that a covariance matrix is positive definite, so that
every portfolio containing these assets is guaranteed to have positive variance.
The outline of this chapter is as follows: Section I.2.2 defines and illustrates the funda-
mental concepts in matrix algebra that are used in portfolio analysis. Starting from the basic
laws of matrix algebra (i.e. addition, multiplication and inversion of matrices), we represent
a set of linear equations in matrix form. This will be used extensively in linear regression
models. And the solution of a set of linear equations is used to calculate the gamma and
vega hedges for an options portfolio in Section III.3.4. The section ends by introducing
quadratic forms. These are used to represent the variance of a linear portfolio, as we shall
see in Section I.2.4.
Section I.2.3 introduces the eigenvalues and eigenvectors of a square matrix and explores
their properties. We show how to compute eigenvalues and eigenvectors and we implement
the method in Excel. Section I.2.4 begins by defining the return and the risk of a linear
portfolio in matrix notation. Then we introduce the covariance matrix of asset returns and
explain why this matrix lies at the heart of portfolio risk analysis. We show how a portfolios
covariance matrix is related to the volatilities and correlations of the constituent asset (or risk
factor) returns, and explain why it must always be positive definite. As well as defining
the concept of definiteness for square matrices, we use our knowledge of eigenvalues and
eigenvectors to test whether a given matrix is positive definite.