Contents

# Introduction to Financial Python

## Linear Algebra

### Introduction

Many papers in statistics and quantitative finance make heavy use of linear algebra, so you need to have a working knowledge of it in order to read and apply them to your trading.

### Vectors

A vector can be thought of as an arrow pointing from the origin to a specific point. Any vector or point can be represented by its coordinates i.e. an array of numbers, such as $(x,y)$ for a 2-dimensional vector, or $(x,y,z)$ for a 3-dimensional one. We usually write a vector as a column:

$\mathbf{v} = \begin{pmatrix} x \\ y \\ z \end{pmatrix}$

The scalar product of two vectors $\mathbf{x}$ and $\mathbf{y}$ in 2-dimensional space is defined as:

$\mathbf{x}^T \mathbf{y} = \begin{pmatrix} x_1 & x_2 \end{pmatrix} \begin{pmatrix} y_1 \\ y_2 \end{pmatrix} = x_1 y_1 + x_2 y_2$

This definition can be easily generalized to n dimensional space. Clearly, we cannot take the scalar product of two vectors with different dimensions.

### Matrices

If we have a few vectors $\mathbf{v}_1, \mathbf{v}_2, \dots, \mathbf{v}_n$ with the same dimension, then we can put them side-by-side to form a matrix. For example, the vectors

$v_1 = \begin{pmatrix} 1 \\ 2 \\ 3 \end{pmatrix} \qquad v_2 = \begin{pmatrix} 2 \\ 2 \\ 2 \end{pmatrix} \qquad v_3 = \begin{pmatrix} 3 \\ 1 \\ 1 \end{pmatrix}$

can be combined to produce a matrix:

$m = \begin{pmatrix} 1 & 2 & 3 \\ 2 & 2 & 2 \\ 3 & 1 & 1 \end{pmatrix}$

m is a 3 × 3 matrix. We typically describe the dimensions of a matrix as $m \times n$ where m = number of rows and n = number of columns.

A square matrix is one with as many rows as columns.

Notation: $x_{ij}$ refers to a specific value in row $i$ and column $j$ of a matrix $X$. For example, $x_{23}$ is the number in the second row and third column of $X$.

### Python Implementation

In Python, the NumPy package deals with linear algebra. The array we learned in the NumPy chapter can be deemed as a vector:

import numpy as np
a = np.array([1,2,3])
b = np.array([2,2,2])
c = np.array([3,1,1])
matrix = np.column_stack((a,b,c))
print matrix
print type(matrix)
[out]:
[[1 2 3]
[2 2 1]
[3 2 1]]


It is worth noticing that we used column_stack() here to ensure that the vectors are vertical and placed side-by-side to form a matrix. Without the column_stack() function, the vectors will be made horizontal and stacked on top of one another:

matrix2 = np.array([a,b,c])
print matrix2
[out]:
[[1 2 3]
[2 2 2]
[3 1 1]]


### Matrix Multiplication

How are two matrices multiplied? Suppose $X = AB$. Each entry $x_{ij}$ of matrix $X$ is the scalar product of row $i$ from matrix $A$ with column $j$ from matrix $B$. This is best illustrated with an example:

$AB = \begin{pmatrix} a_{11} & a_{12} \\ a_{21} & a_{22} \\ a_{31} & a_{32} \end{pmatrix} \begin{pmatrix} b_{11} & b_{12} \\ b_{21} & b_{22} \end{pmatrix} = \begin{pmatrix} x_{11} & x_{12} \\ x_{21} & x_{22} \\ x_{31} & x_{32} \end{pmatrix}$ $x_{\color{red}11} = a_{{\color{red}1} 1} b_{1{\color{red} 1}} + a_{{\color{red}1} 2} b_{2 {\color{red}1}}$ $x_{\color{red}12} = a_{{\color{red}1} 1} b_{1 {\color{red}2}} + a_{{\color{red}1} 2} b_{2 {\color{red}2}}$ $x_{\color{red}21} = a_{{\color{red}2} 1} b_{1 {\color{red}1}} + a_{{\color{red}2} 2} b_{2 {\color{red}1}}$ $x_{\color{red}22} = a_{{\color{red}2} 1} b_{1 {\color{red}2}} + a_{{\color{red}2} 2} b_{2 {\color{red}2}}$ $\vdots$

In NumPy, we can multiply matrices with the dot() function:

A = np.array([[2,3],[4,2],[2,2]])
B = np.array([[4,2],[4,6]])
x = np.dot(A,B)
print x
[out]:
[[20 22]
[24 20]
[16 16]]


Since matrix multiplication is defined in terms of scalar products, the matrix product $AB$ exists only if $A$ has as many columns as $B$ has rows. It's useful to remember this shorthand: (m × n) × (n × p) = (m × p) which means that an (m × n) matrix multiplied by an (n × p) matrix yields an (m × p) matrix.

Reversing the order of multiplication results in an error since B does not have as many columns as A has rows:

x = np.dot(B,A)


A natrual consequence of this fact is that matrix multiplication is not commutative. In other words, $AB \neq BA$ in general.

### Inverse

An identity matrix is a square matrix with ones on the main diagonal and zeros elsewhere. Here is an $n \times n$ identity matrix:

$I_n = \begin{pmatrix} 1 & 0 & 0 & ... & 0 \\ 0 & 1 & 0 & ... & 0 \\ 0 & 0 & 1 & ... & 0 \\ \vdots & \vdots & \vdots & \ddots & \vdots \\ 0 & 0 & 0 & ... & 1 \end{pmatrix}$

Multiplying any matrix by an identity matrix (of the correct shape) is like multiplying a number by 1. Concretely, if $A$ is an $m \times n$ matrix, then:

$I_mA = AI_n = A$ $A^{-1}$ is the inverse matrix of a square matrix $A$ if: $AA^{-1} = I = A^{-1}A$

Some caveats:

• A rectangular matrix will not have an inverse, but it may have a pseudoinverse (not covered in this tutorial).
• A square matrix may not have an inverse i.e. it may be "singular".
• If a square matrix has an inverse, then its inverse is unique.

Inverse matrices are computed using the Gauss-Jordan method. In NumPy, we use the linalg.inv() function to do it:

print matrix
print '\n-------------------------\n'
print np.linalg.inv(matrix)
[out]:
[[1 2 3]
[2 2 1]
[3 2 1]]

-------------------------

[[ 0.   -1.    1.  ]
[-0.25  2.   -1.25]
[ 0.5  -1.    0.5 ]]


Now let's check if the multiplication is $I$:

inverse = np.linalg.inv(matrix)
print np.dot(matrix, inverse)
print '\n-------------------------\n'
print np.dot(inverse,matrix)
[out]:
[[  1.00000000e+00  -6.66133815e-16   6.66133815e-16]
[  0.00000000e+00   1.00000000e+00   1.11022302e-16]
[  0.00000000e+00  -2.22044605e-16   1.00000000e+00]]

-------------------------

[[  1.00000000e+00  -4.44089210e-16  -2.22044605e-16]
[  6.66133815e-16   1.00000000e+00   0.00000000e+00]
[  0.00000000e+00   0.00000000e+00   1.00000000e+00]]


Not surprisingly, we ended up with an identity matrix. We can form a non-invertible matrix by making one of its rows a multiple of another:

singular = np.array([[1,2,3],[1,2,3],[3,3,3]])
inv = np.linalg.inv(singular)
[out]: numpy.linalg.linalg.LinAlgError: Singular matrix


### Linear Equations

A common problem in linear algebra is solving linear equations. Consider the following linear equations:

$2x + y - z = 8$ $-3x - y + 2z = -11$ $-2x + y + 2z = -3$

If we let:

$A = \begin{pmatrix} 2 & 1 & -1 \\ -3 & -1 & 2 \\ -2 & 1 & 2 \end{pmatrix} \qquad \mathbf{x} = \begin{pmatrix} x \\ y \\ z \end{pmatrix} \qquad \mathbf{b} = \begin{pmatrix} 8 \\ -11 \\ -3 \end{pmatrix}$

Then the linear equations above can be written as $A\mathbf{x} = \mathbf{b}$

If A is invertible, then we can multiply $A^{-1}$ on both sides of the equation to obtain the solution:

$A^{-1}A \mathbf{x} = A^{-1}\mathbf{b}$ $\mathbf{x} = A^{-1}\mathbf{b}$

As long as $A^{-1}$ exists, we can compute it to solve the linear equations:

A = np.array([[2,1,-1],[-3,-1,2],[-2,1,2]])
b = np.array([[8],[-11],[-3]])
inv_A = np.linalg.inv(A)
print np.dot(inv_A, b)
[out]:
[[ 2.]
[ 3.]
[-1.]]


The solution is x = 2, y = 3, z = −1. However, computing the inverse matrix is not recommended, since it is numerically unstable i.e. small rounding errors can dramatically affect the result.

Instead, NumPy solves linear equations by LU decomposition:

print np.linalg.solve(A, b)
[out]:
[[ 2.]
[ 3.]
[-1.]]


Of course, we get the same solution. We can check the correctness of the solution by substituting x, y and z into the linear equations.

### Summary

In this chapter we have introduced vectors, matrices, inverse matrices and linear equations. Some applications in finance include: finding arbitrage opportunities by solving linear equations, computing portfolio variance, etc. In the next chapter, we will introduce modern portfolio theory and CAPM.

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