Introduction to Financial Econometrics

Appendix Matrix Algebra Review

Eric Zivot
Department of Economics
University of Washington
January 3, 2000
This version: February 6, 2001

Matrix Algebra Review

A matrix is just an array of numbers. The dimension of a matrix is determined by

the number of its rows and columns. For example, a matrix A with n rows and m
columns is illustrated below

a11 a12 . . . a1m

a21 a22 . . . a2m

A = ..
..
..
.
(nm)
. ... .
an1 an2 . . . anm
where aij denotes the ith row and j th column element of A.
A vector is simply a matrix with 1 column. For example,

x1
x2

x = ..
(n1)
.
xn

is an n 1 vector with elements x1 , x2 , . . . , xn . Vectors and matrices are often written

in bold type (or underlined) to distinguish them from scalars (single elements of
vectors or matrices).
The transpose of an n m matrix A is a new matrix with the rows and columns
of A interchanged and is denoted A0 or A| . For example,

1 4
1 2 3
, A0 = 2 5
A =
4
5
6
(32)
(23)
3 6
1

x
(31)

1
= 2 ,
3

x0 =

(13)

1 2 3 .

A symmetric matrix A is such that A = A0 . Obviously this can only occur if A

is a square matrix; i.e., the number of rows of A is equal to the number of columns.
For example, consider the 2 2 matrix

1 2
A=
.
2 1
Clearly,
0

A =A=

1.1
1.1.1

1 2
2 1

Basic Matrix Operations

Addition and subtraction

Matrix addition and subtraction are element by element operations and only apply
to matrices of the same dimension. For example, let

4 9
2 0
A=
, B=
.
2 1
0 7
Then
A+B =
AB =
1.1.2

4 9
2 1
4 9
2 1

2 0
0 7
2 0
0 7

=
=

4+2 9+0
2+0 1+7
42 90
20 17

6 9
2 8

2 9
2 6

Scalar Multiplication

Here we refer to the multiplication of a matrix by a scalar number. This is also an

element-by-element operation. For example, let c = 2 and

3 1
A=
.
0 5
Then
cA=

2 3 2 (1)
2 (0)
25

6 2
0 10

1.1.3

Matrix Multiplication

Matrix multiplication only applies to conformable matrices. A and B are conformable

matrices of the number of columns in A is equal to the number of rows in B. For
example, if A is m n and B is m p then A and B are conformable. The mechanics
of matrix multiplication is best explained by example. Let

1 2
1 2 1
and B =
.
A =
3 4
3 4 2
(22)
(23)
Then
A B

(22)

(23)

1 2
3 4

1 2 1

3 4 2

11+23 12+24 11+22

=
31+43 32+44 31+42

7 10 5
=
= C
15 22 11

(23)

The resulting matrix C has 2 rows and 3 columns. In general, if A is n m and B

is m p then C = A B is n p.
As another example, let

1 2
2
A = 3 4 and B = 6 .
(22)
(21)
Then
A B

(22)

(21)

5
=

15+26
=
35+46

17
=
.
39
1 2
3 4

As a &nal example, let

Then

1
4

x = 2 , y = 5 .
3
6

x0 y = 1 2 3 5 = 1 4 + 2 5 + 3 6 = 32
6
3

1.2

The Identity Matrix

The identity matrix plays a similar role as the number 1. Multiplying any number by
1 gives back that number. In matrix algebra, pre or post multiplying a matrix A by
a conformable identity matrix gives back the matrix A. To illustrate, let

1 0
I=
0 1
denote the 2 dimensional identity matrix and let

a11 a12
A=
a21 a22
denote an arbitrary 2 2 matrix. Then

1 0
a11 a12
IA =

a21 a22
0 1

a11 a12
=
=A
a21 a22
and
AI =
=

1.3

a11 a12
a21 a22
a11 a12
a21 a22

1 0

0 1

= A.

Inverse Matrix

To be completed.

1.4

Representing Summation Using Vector Notation

Consider the sum

n
X
k=1

xk = x1 + + xk.

Let x = (x1 , . . . , xn )0 be an n 1 vector and 1 = (1, . . . , 1)0 be an n 1 vector of

ones. Then

1
n
X

.
0
.
x 1 = x1 . . . xn . = x1 + + xk =
xk
k=1
1
4

and

x1
n
X

.
0
1 x = 1 . . . 1 .. = x1 + + xn =
xk .
k=1
xn

Next, consider the sum of squared x values

n
X
k=1

x2k = x21 + + x2n .

This sum can be conveniently represented

.1
0
x x = x1 . . . xn ..
xn

as

x2k .
= x21 + + x2n =
k=1

Last, consider the sum of cross products

n
X
k=1

xk yk = x1 y1 + xn yn .

This sum can be compactly represented by

y1
n
X

.
0
.
x y = x1 . . . xn . = x1 y1 + xn yn =
xk yk .
k=1
yn
Note that x0 y = y0 x.

1.5

Representing Systems of Linear Equations Using Matrix

Algebra

Consider the system of two linear equations

x+y = 1
2x y = 1

(1)
(2)

which is illustrated in Figure xxx. Equations (1) and (2) represent two straight lines
which intersect at the point x = 23 and y = 13 . This point of intersection is determined
by solving for the values of x and y such that x + y = 2x y 1 .
1
Soving for x gives x = 2y. Substituting this value into the equation x + y = 1 gives 2y + y = 1
and solving for y gives y = 1/3. Solving for x then gives x = 2/3.

The two linear equations can be written in matrix form as

1 1
x
1
=
2 1
y
1
or
Az=b
where
A=

1 1
2 1

, z=

x
y

and b =

1
1

If there was a (2 2) matrix B, with elements bij , such that B A = I, where I

is the (2 2) identity matrix, then we could solve for the elements in z as follows. In
the equation A z = b, pre-multiply both sides by B to give
BAz

or

x
y

b11 b12
b21 b22

= Bb
= I z = B b
= z = B b

1
1

b11 1 + b12 1
b21 1 + b22 1

If such a matrix B exists it is called the inverse of A and is denoted A1 . Intuitively, the inverse matrix A1 plays a similar role as the inverse of a number.
Suppose a is a number; e.g., a = 2. Then we know that a1 a = a1 a = 1. Similarly,
in matrix algebra A1 A = I where I is the identity matrix. Next, consider solving
the equation ax = 1. By simple division we have that x = a1 x = a1 x. Similarly, in
matrix algebra if we want to solve the system of equation Ax = b we multiply by
A1 and get x = A1 b.
Using B = A1 , we may express the solution for z as
z = A1 b.
As long as we can determine the elements in A1 then we can solve for the values of
x and y in the vector z. Since the system of linear equations has a solution as long as
the two lines intersect, we can determine the elements in A1 provided the two lines
are not parallel.
There are general numerical algorithms for &nding the elements of A1 and typical
spreadsheet programs like Excel have these algorithms available. However, if A is a
(2 2) matrix then there is a simple formula for A1 . Let A be a (2 2) matrix such
that

a11 a12
.
A=
a21 a22
6

Then
A

1
=
a11 a22 a21 a12

a22 a12
a21 a11

By brute force matrix multiplication we can verify this formula

1
a22 a12
a11 a12
1
A A =
a21 a22
a11 a22 a21 a12 a21 a11

1
a22 a11 a12 a21
a22 a12 a12 a22
=
a11 a22 a21 a12 a21 a11 + a11 a21 a21 a12 + a11 a22

1
a22 a11 a12 a21
0
=
0
a21 a12 + a11 a22
a11 a22 a21 a12

a22 a11 a12 a21

0
a11 a22 a21 a12
=
a21 a12 +a11 a22
0
a11 a22 a21 a12

1 0
=
.
0 1
Let s apply the above rule to &nd the inverse of A in our example:

1 1
1
1 1
1
3
A =
= 23 1
.
1 2 2 1
3
3
Notice that
1

A A=
Our solution for z is then

1
3
2
3

1
3
1
3

1 1
2 1

1 0
0 1

z =
A1 b
1
1
1
3
3
=
2
1
1
32 3
x
3
=
=
1
y
3
so that x = 23 and y = 13 .
In general, if we have n linear equations in n unknown variables we may write the
system of equations as
a11 x1 + a12 x2 + + a1n xn = b1
a21 x1 + a22 x2 + + a2n xn = b2
..
.
. = ..
an1 x1 + an2 x2 + + ann xn = bn
7

which we may then express

a11
a21

..
.
an1

or

in matrix form as

a12 a1n

a22 a2n

..
.
an2 ann

x1
x2
..
.
xn

b1
b2
..
.
bn

A x = b.

(nn)

(n1)

(n1)

The solution to the system of equations is given by

x = A1 b
where A1 A = I and I is the (n n) identity matrix. If the number of equations is
greater than two, then we generally use numerical algorithms to &nd the elements in
A1 .

Further Reading

Excellent treatments of portfolio theory using matrix algebra are given in Ingersol
(1987), Huang and Litzenberger (1988) and Campbell, Lo and MacKinlay (1996).

Problems

To be completed

References
[1] Campbell, J.Y., Lo, A.W., and MacKinlay, A.C. (1997). The Econometrics of
Financial Markets. Priceton, New Jersey: Princeton University Press.
[2] Huang, C.-F., and Litzenbeger, R.H. (1988). Foundations for Financial Economics. New York: North-Holland.
[3] Ingersoll, J.E. (1987). Theory of Financial Decision Making. Totowa, New Jersey:
Rowman & Little&eld.