Mathematics for finance Deprtment of Accounting and Finance

CHAPTER TWO
MATRIX ALGEBRA AND ITS APPLICATIONS
Algebra - is a part of mathematics that deals with operations (+, -, x and÷).
Matrix is a rectangular array of real numbers arranged in m rows and n columns. Like sets, it
is symbolized by a bold face capital letter enclosed by brackets or parentheses as:


a 11 a12       a 1n


A  a 21 a 22       a 2n  In which aij are
 
 a m1 a m2       a mn 

real numbers?
Each number appearing in the array is said to be an element or component of the matrix.
Elements of a matrix are designated using a lowercase form of the same letter used to
symbolize the matrix itself. These letters are subscript, as a ij, to give the row and column
location of the element within the array. The first subscript always retirees to the row
location of the element; the second subscript always refers to its column location. Thus,
component aij is the component located at the intersection of the i th row and the jth column.
The number of rows, m, and the number of columns, n, of the array give its order, or its
dimensions, mxn (read “m by n”) = a mxn or [aij] (mxn).
Example: the following are examples of matrices.
1 7 
 
A

 5

 4

3 

2
 This is a 3 x 2 matrix element: a12= 7 a21 = 5 a32 = 2 a23 = x
 

because is a 3 x 2 matrix.

1 5 9 15
2 6 10 20
X=   this is a 4 x 4 matrix elements x44 = 45 x32 = 7
3 7 11 30
 
 4 8 12 45

IMPORTANCE OF MATRICES
Matrices provide a most convenient vehicle for organizing and storing large quantities of
data. Because the basic idea is to organize the data, we cannot over emphasize the
importance of the location of each number with in the matrix. It is not simply a matter of
putting numbers in to rows and columns; each row-column location with in each matrix
carries with it special interpretation; a matrix is, in essence, a tool for organizing vast
quantities of data. Matrices are used to represent complex systems and operations by
compact entities. Matrix representations are possible in:
- Transportation matrix
- Distance matrix
- Cost matrix
- Brand switching

TYPES OF MATRICES
1. VECTOR MATRIX - is a matrix which consists of either one row or one column. That is, it
is an mx1 or a 1 x n matrix.
1.1. Row vector = is a 1 x n matrix
E.g. W = [-1, 0, 6]
1.2 Column Vector - is a mx1 matrix

Chapter Two: Matrix Algebra and its Applications Page 1

 Mathematics for finance Deprtment of Accounting and Finance

 2
 5 
E.g. B = 


7


 0

The transpose of an mxn matrix denoted A -t is an nxm matrix whose rows are the columns in
A (in the same order) and whose columns are the rows in A (in the same order).
1 2 3 10 
 

If 
A  4

 7
5

8
6

9

11 

12 
then A-t =
 

Note that aij-t = aij

The transpose of a row vector is a column vector and the transpose of a column vector is a
row vector.

2. SQUARE MATRIX - is a matrix that has the same number of rows and columns. It is also
called an nth order matrix.
1 0
E.g. 2x2, A  
.
0 1

 


3. NULL (ZERO) MATRIX - is a matrix that has zero for every entry. It is generally denoted
by Omn. In matrix operations it is used in much the same way that the number zero is used in
regular algebra. Thus, the sum of a zero matrix and any matrix gives that given matrix and
the product of a zero matrix and any matrix equals that given a zero matrix.
4. IDENTITY MATRIX - a square matrix in which all of the primary diagonal entries are ones
and all of the off diagonal entries are zeros. Generally it is denoted as I n. Primary diagonal
represents: a11, a22, a33, a44, --- ann entries.
1 0 

1 0 0 0
0
I2 = A  
, I4 =
0 1 0
A   
0 1
 0 0 1 0
 

 
  0 0 0 1

The product of any given matrix and the identity matrix is the given matrix it self. That is, A
x I = A and I.A = A. Thus, the identity matrix behaves in matrix multiplication like the
number 1 in an ordinary arithmetic.
5. SCALAR MATRIX - is a square matrix where elements on the primary diagonal are the
same and the rest zeros.
NB: An Identity matrix is a scalar matrix, but a scalar matrix may not be an identity matrix
6. DIAGONAL MATRIX- a square matrix where elements on the primary diagonal are
consecutive and others zeros.
7. EQUAL MATRICES -Two matrices A & B, are said to be equal only if they are of the same
dimensions and if each element in A is identical to its corresponding element in B; that is, if
and only if aij = bij for every pair of subscripts i and j. If A = B, then B = A; or if A≠B, then
B ≠A.
1 2 1 2
A  
Is equal to B = A  
3 4 3 4

 
 
 

1 2 4 2
However; A 
3

4
is not equal to C = A 
3

1

 
 
 


Even though they contain the same set of numerical values, A and C are not equal because
their corresponding elements are not equal; that is, a11 ≠ C11 and so on.

MATRIX OPERATIONS (ADDITION, SUBTRACTION, and MULTIPLICATION)

Matrix Addition (subtraction)
Two matrices of the same dimensions are said to conformable for addition. The addition is
performed by adding corresponding elements from the two matrices and entering the reset in
the same row-column position of a new matrix [element-wise addition].

Chapter Two: Matrix Algebra and its Applications Page 2

 Mathematics for finance Deprtment of Accounting and Finance

If A and B are two matrices, each of size mxn, then the SUM of A and B is the mxn matrix
C whose elements are:
Cij = Aij + bij for i = 1, 2, ------- m
j = 1, 2, -------- n.

Laws of Matrix Addition

The operation of adding two matrices that are conformable for addition has these two basic
properties:
1. A + B = B + A ---- The commutative law of matrix addition.
2. (A+B) +C = A+ (B+C) -------- the associative law of matrix addition.

7 9 
+ 
8

 10
=
 

Given that two matrices do have the same dimension, the way we subtract a matrix from
another matrix is the same as the way we add two matrices.

Matrix Multiplication
A. Matrix Multiplication by a Constant (Scalar Multiplication)
A matrix can be multiplied by a constant by multiplying each component in the matrix by a
constant. The result is a new matrix of the same dimensions as the original matrix.

If K is any real number and A is an mxn matrix, then the product KA is matrix whose
components are given by k times the corresponding component of A; that is,
KA= [Kaij] (mxn).

E.g. If X = [6 5 7], then 2X = [(2x6) (2x5) (2x7)]

2X = [12 10 14]
Laws of Scalar Multiplication
The operation of multiplying a matrix by a constant (a SCALAR) has the following basic
properties. If x and y are real numbers and A and B are mxn matrices, conformable for
addition, then:
1. XA = AX
2. (X+Y)A = XA+YA
3. X (A+B) = XA + XB
4. X (YA) = XY (A)
B. Vector-by-Vector multiplication
In multiplying two vectors always a row vector is written in the first position and the column
vector in the second position. Each component of a row vector is multiplied by the
corresponding component of the column vector to obtain a result known as PARTIAL
PRODUCT. The sum of all partial products is called INNER/DOT PRODUCT of two
vectors, and this is a number not a vector. In other words, Vector- by- Vector results in a real
number rather than a matrix.
E.g. consider the product (AB) of the following row and column vectors.
 2

A  3 6 ,
 5 
4 2 B= 


7


 0

3x2=6
4 x 5 = 20 partial products

Chapter Two: Matrix Algebra and its Applications Page 3

 Mathematics for finance Deprtment of Accounting and Finance

-2 x 7 = -14
6x0=0
12 Inner/Dot Product

C. Matrix by Matrix Multiplication

If A and B are two matrices, the product AB is defined if and any if the number of
columns in A is equal to the number of rows in B, i.e., if A is an m x n matrix, B should
be an n x b. If this requirement is met, A is said to be conformable to B for multiplication.
The matrix resulting from the multiplication has dimensions equivalent to the number of
rows in A and the number of columns in B.
Matrix by matrix multiplication indicates a row by column multiplication, where the entry in
the ith row and jth column of the product AB is obtained by multiplying the entries in the i th
row of A by the corresponding entries in the j th column of B and then adding the results. That
is, to obtain the entry in the ith row and jth column of the product AB, use the ith raw of A and
the jth column of B in the following form:

The first element in the raw is multiplied by the first element in the column; the second
element in the row is multiplied by the second element in the column and so on until the nth
row element is multiplied by nth column element. These products are then summed up to
obtain the single number that is the product of the two vectors.

If A is a matrix of dimension n x m (which has m columns) and B is a matrix of dimensions

p x q (which has p rows) and it m is different from p, the product AB is not defined. That is,
multiplication of matrices is possible only if the number of columns of the first equals the
number of rows of the second.
If A is of dimension n x m and if B is of dimension m x p, then the product A.B is of
dimension n x p.
Example:
2 3 4   1 7
A 
6 9

7
B=  0


8 



 
  5 1 

A.B = (2x-1) + (3x0) + (4x5) (2x7) + (3x8) + (4x1)

= 18 = 42

= (6x-1) + (9x0) + (7x5) (6x7) + (9x8) + (7x1)

= 29 =121

 18 42 
AB =  29 121


Special Properties of Matrix Multiplication

1. The Associative and distributive laws of ordinary algebra apply to matrix multiplication.
Given three matrices A, B and C, which are conformable for multiplication?
 A (BC) = (AB) C -------------------- Associative law, not C (AB).
 A (B+C) = AB + AC -------------- Distributive law
 (A+B) C = AC + AB -------------- Distributive law
2. The commutative law of multiplication does not apply to matrix multiplication. For any two
real numbers X and Y, the product XY is always identical to the product YX. But for two
matrices A and B, it is not generally true that AB equals BA. (In the product AB, we say that
B is pre multiplied by A and that A is post multiplied by B). In many instances for two

Chapter Two: Matrix Algebra and its Applications Page 4

 Mathematics for finance Deprtment of Accounting and Finance

matrices A and B, the product AB may be defined while the product BA is not defined, or
vice versa.
In some special cases, AB does equal BA. In such special cases A and B are said to
Commute.
3. The product of two matrices can be the zero matrixes even though neither of the two matrices
themselves is zero matrix! We cannot conclude from the result AB = 0 that at least one of
the matrices A or B is a zero matrix.
 3 0 0  0 0 0 
A =  2


0 0

0 
, B =  7


 10 4


, AB =
1 0   8 3 2 
 0 0 0
 0 0 0
 

 0 0 0


4. We cannot, in matrix Algebra, necessarily conclude from the results AB = AC that B = C,

even if matrix A is not equal to a zero matrix. Thus the CANCELLATION LAW does not
hold, in general, in matrix multiplication.
1 3  4  1 1 2
A
 2 

6
, B= 
2 5

 , C = 3 2 
4

 
 
 
 
 


 10 14 
AB = AC = 
  20

 28
but B ≠ C.
 

The Multiplicative Inverse of a Matrix

If A is a square matrix of order n, then a square matrix of its inverse (A -1) of the same order
n is said to be the inverse of A, if and only if AA-1 = I = A-1A.
Two square matrices are inverse of each other if their product is the identity matrix: I = AA -1
= A-1A.
Not all matrices have an inverse. In order for a matrix to have an inverse, the matrix must,
first of all, be a square matrix. Still not all square matrices have inverse. If a matrix has an
inverse, it is said to be INEVITABLE or NON-SINGULAR. A matrix that doesn’t have an
inverse is said to be SINGULAR. An inevitable matrix will have only one inverse; that is, it
a matrix does have an inverse, and that inverse is unique.
In short:
 Inverse of a matrix is defined only for square matrices
 If B is an inverse of A, then A is also an inverse of B.
 Inverse of a matrix is unique.
 If matrix A has an inverse, A is said to be inevitable and not all square matrices are
inevitable.
E.g.
Finding the Inverse of a Matrix
Let us begin by considering a tabular format where the square matrix, A is augmented with
an identity matrix of the same order, as [A/I]. This process is called Adjoining.
Now, if the inverse matrix A-1 were known, we could multiply the matrices on each side of
the vertical line by A-1, as [AA-1/A-1I]

Then, because AA-1 = I and A-1 I = A-1, we would have [I/A-1]. We do not follow this
procedure, because the inverse is not known at this juncture; we are trying to determine the

Chapter Two: Matrix Algebra and its Applications Page 5

 Mathematics for finance Deprtment of Accounting and Finance

inverse. We instead employee a set of permissible row operations on the augmented matrix
[A/I] to transform A on the left side of the vertical line in to an identity matrix (I). As the
identity matrix is formed on the left of the vertical line, the inverse of A is formed on the
right side. The allowable manipulations are called ELEMENTARY ROW OPERATIONS.
These Elementary Row Operations are operations permitted on the row of a matrix.
In a matrix Algebra there are 3 types of row operations.
i. Any pair of row in a matrix may be interchanged /Exchange operations/.
Interchanging rows.
ii. A row can be multiplied by any non-zero real number /Multiple operations/. The
multiplication of any row by a non-zero number.
iii. A multiple of any row can be added to any other row /Add-A-Multiple operations/.
The addition /subtraction of (a multiple of) one row to/from) another row.
  2 6 7
E.g. 1. , B=  4


3 2 


= interchanging rows
 

2. B= = multiplying the first row by 2.

4 3 2 
3. B= 
6 12

11
= Multiplying the first row by 2 and
 

add to 2nd row.

Theorem on row operations

A row operation performed on product of two matrices is equivalent to row operation
performed on the pre-factor.
Consider the following AB = C
1 2 
9 13 
B= 1
 1 
 , C=  13 19 

 2 3 
  

Interchange R1 with R2
1 2 
 13 19 
B= 1
 1 
 C, = 9 13 

 2 3 
  

Basic Procedures to Find the Inverse of a Square Matrix

1. To get ones first in a column and next zeros (within a given column)
2. To get zeros first in a matrix and next ones.
Ones First: Try to set ones first in a column and then zeros of the same column. Go from
left to right
Zeros First: Find the off diagonal zeros first, and following this obtain ones on the main
diagonal. It can simplify the work involved in hand calculation by avoiding fractions until
the last step.
MATRIX APPLICATIONS
Solving Systems of Linear Equations
1. n by n systems: Systems of linear equations can be solved using different methods. Some
are:
 Elimination method for 2 variable problems (equations).
 Matrix method
i. Inverse method
ii. Cramer’s rule – using determinants (independent study)

Chapter Two: Matrix Algebra and its Applications Page 6

 Mathematics for finance Deprtment of Accounting and Finance

iii. Gaussian Method.

Inverse Method
To solve systems of linear equations using the inverse method the coefficient matrix should
be inevitable, and it involves the following steps:
1. Put all equations in a matrix form (square matrix form).
2. Find the inverse of the coefficient matrix.
3. Multiply the inverse with right hand side values (vector of constants)
2. X+Y = 2
2x + 2y= 4

The inverse method provides us with unique solution, or no solution and infinite solution
(with out separating them).

Gaussian Method: developed by Karl F. Gauss (1771-1855)

Solving systems of linear equations using the Gaussian method involves the following steps:
1. Write all equations in a matrix form.
2. Change coefficient matrix in to identity matrix and apply the same commentary
row operations on the vector of constants
3. The resulting value (of the RHS vector) will be the solution.
Ax = B
Ix = C
x=C
The Gaussian Method helps us to obtain: Unique solution, No. Solution and Infinite solution
Example 1: 2X + 3Y = 4
X + 2Y = 2
Step 1. Change it into matrix form

2 3 X = 4
1 2 Y 2

Coefficient unknown vector of

Matrix matrix constant

Step: 2. Augmentation
2 3 4
1 2 2

Step: 3. Change the coefficient matrix into identity form by applying elementary row
operation (use ones first method)
2 3 4
1 2 2

Change first the primary diagonal entry from the first row into positive one. Possible
operation is exchange row one with row two.
1 2 2
2 3 4

Next change the remaining numbers in the first column into zero, this case number 2
Now multiply the 1st row by –2 & add the result to row –2

Chapter Two: Matrix Algebra and its Applications Page 7

 Mathematics for finance Deprtment of Accounting and Finance

1 2 2
0 -1 0

Then proceed to column 2 and change the primary diagonal entry i.e. –1 into 1
Multiply the 2nd row by –1 (-1R2)
1 2 2
0 1 0
Now change the remaining number with in the same column (column –2) into zero i.e.
number 2
Multiply 2nd row by –2 and add the result to the 1st row
1 0 2
0 1 0

Therefore X = 2 and Y = 0

Example 2. X+Y=2
2X + 2Y = 4

Step-1
1 1 X = 2
2 2 Y 4

Step-2 1 1 2
2 2 4

Multiply Row-1 by –2 & add the result to raw-1 (-2R1 + R2)

1 1 2
0 0 0

The next step is changing the primary diagonal entry in the 2 nd row to 1. But there is no
possible operation that can enable you to change it in to number 1

Therefore the implication is that you can’t go further but we can observe something from the
result. And it is implying an infinite solution case

Example 3. X+Y=5
X+Y=9

Step 1. 1 1 X = 5
1 1 Y 9

Step 2 1 1 5
1 1 9

Change the encircled number above in to zero

Multiply the first row by –1 & add the result to the 2 nd row.

1 1 5

Chapter Two: Matrix Algebra and its Applications Page 8

 Mathematics for finance Deprtment of Accounting and Finance

0 0 4

0 = 4 no solution

There is no possible operation that we can apply in order to change the primary diagonal
entry in the 2nd column without affecting the first column structure. Therefore stop there, but
here we can observe something i.e. it is no solution case
Therefore, Gaussian method makes a distinction between no solution and infinite solution,
unlike the inverse method.
Summarizing our results for solving an “n” by “n” system, we start with matrix (A/B), and
attempt to transform it in to the matrix (I/C).
One of the three things will result:
1. An n by n matrix with the unique solution; e.g.

1 0 0 10
 
0 1 0  5
0 0 1 3 

2. A row that is all zeros except in the constant column, indicating that there are no solutions;
e.g.

1 0 0 3
 
0 1 0 5
0 0 0 7


3. A matrix in a form different from (1) and (2), indicating that there are an unlimited number of
solutions. Note that for an n by n system, this case occurs when there is a row with all zeros,
including the constant column; e.g.

1 0 2 5
 
0 1 3  3
0 0 0 0 

2. M by n linear systems
The mxn linear systems are those systems where the number of rows (m) and number of
columns (n) are unequal or it is the case where the number of equations (m) and the number
of variables (n) are unequal. And it may appear as m>n or m<n.
2.1 Linear equations where m>n
To solve an m by n systems of equations with m>n, we start with the matrix (A/B), and
attempt to transform it in to the matrix (I/C). One of the three things will result:
1. An n by n identity matrix above m-n bottom rows that are all zeros, giving the unique
solution
E.g.

2. A row that all zeros except in the constant column, indicating that there are no solutions.
E.g.

3. A matrix in a form different from (1) and (2), indicating that there are an unlimited
number of solutions.

Chapter Two: Matrix Algebra and its Applications Page 9

 Mathematics for finance Deprtment of Accounting and Finance

E.g.

2.2. Linear equations where m<n

Our attempt transform (A/B) in to (I/C) in the case where m<n will result in:
1. A row that is all zeros except in the constant column, indicating that there are no
solutions. Or
2. A matrix in a form different from (1), indicating that there are an unlimited number of
solutions.
“EVERY SYSTEM OF LINEAR EQUATIONS HAS NO SOLUTION, EXACTLY
ONE SOLUTION OR INFINITELY MANY SOLUTIONS.”

Cramer’s Rule for Solving Linear Equation

Cramer’s rule is a method that is useful primarily for low order system, with two or three
unknowns. Cramer’s rules states that each unknown can be expressed as the ratio of two
matrix determinants.
e.g Assume there are two linear equations having two unknown variables.
a11X1 + a12X2 = b1
a21X1 + a22X2 = b2
Here the unknown are x1&x2, the right hand sides are b1 & b2 and the coefficients are aij
 Cramer’s rule requires finding the quotient of the determinants of matrices associated to
the system and can be used when the determinant of the coefficient matrix is none zero.
The coefficient matrix A= a11 a12
a 21 a22
Assume the determinant of A is different from 0 the Cramer’s rule gives the solution for unknown variables.
Use the Cramer’s rule to solve the 2x2 Use the Cramer’s rule to solve the 3x3 system of
system of linear equation linear equation
e.g. 3x1 + 7x2 = 41 e.g. 4x1 + 2x2 + 7x3 = 35
8x1 + 9x2 = 61 3x1 + x2 +8 x3 = 25
5x1 + 3x2 + x3 = 40
Required: Find the values of the unknown variables for the above all examples?
Exercise
(Assignment)
a) 3x1 + 8x2 + 2x3 = 67 b) 5p1 + p2 + 2p3 = -6 c) 16x – 3y + 10z = 8
4x1 + 6x2 +9 x3 = 36 2p 1 +px3 – 9p2 = - -4x + 18y + 14z 3 =
7x1 + x2 + 5x3 = 49 14 12
3p 1 + p2 – 8px3 = - 28x + 42y – 6z =
58 18
Required: Find the values of the unknown variables for the above all?

MARKOV CHAINS
Concept, Model and Solutions
This model is a forecasting model. It is probabilistic/ stochastic model. A Russian
mathematician called Andrew Markov around 1907 developed this model.
Markov chains are models which are useful in studying the evolution of certain system over
repeated trials. These repeated trails are often successive time periods where the state (out

Chapter Two: Matrix Algebra and its Applications Page 10

 Mathematics for finance Deprtment of Accounting and Finance

come, condition) of the system in any particular time period cannot be determined with
certainty. Therefore, a set of transition probabilities is used to describe the manner in which
the system makes transition from one period to the next. Hence, we can predict the
probability of the system being in a particular state at a given time period. We can also talk
about the long run/equilibrium, steady state.

System - which we want to study, machine, and person

Trials - successive time period any convenient length of time day, week, month, year, etc.
State/out come, condition - the system can have various number of out comes.
Transition probabilities - set of input data, and are assumed to be constant.
Long/stead state - the system cannot change any more. There is the same probability between
n and n + 1 period after the long period.
The necessary assumptions of the chain are:
1. The system has a finite number of states - the out comes of the system should be finite.
2. The system condition/outcome, state in any given period depends on its state in the
preceding period and on the transition probabilities
3. The transition probabilities are constant over time.
4. Changes in the system will occur once and only once each period.
5. The transition period occurs with regularities.
6. The states are both mutually exclusive and collectively exhaustive.
7. The system is a closed one, that is, there will be no arrival or exits from the system.

Information flow in the Analysis

The Markov model is based on two sets of input data
 The set of transition probabilities.
 The existing or initial or current conditions or states.
The Markov process, therefore, describes the movement of a system from a certain state in
the current state/ time period to one of the possible states in the next stage. The system move
in an uncertain environment all that is known is the probability associated with any
possible move or transition. This probability is known as transition probability
symbolized by Pij. It is the likelihood that the system which is currently in state i will Smoke
to state j in the next period.

From these inputs the model makes two predictions usually expressed as vectors:
1. The probabilities of the system being in any state at any given future time period.
2. The long run / equilibrium, steady state probabilities.
The set of transition probabilities are necessary for both predictions (time period n, and
steady state), but the initial state is needed for only the first prediction.

Input data Prediction (outcome)

Set of transition Steady states or long
Probabilities about run states
the past

The probability of the system being in any

Currently / initial
state at any given time
States

Chapter Two: Matrix Algebra and its Applications Page 11

 Mathematics for finance Deprtment of Accounting and Finance

about today

N.B. Markov chain analysis used among other things in Market share Analysis. The
example below shows this.
1. Currently it is known that 80% of customers shop at store 1 and 20% shop at store 2. In
reviewing a past data suppose we find that out of all customers who shopped at store 1 in a
given week 90% remain loyal for the next week (store one again), 10% switch to store 2. Out
of all customers who shopped at store 2, in a given week 80% remain loyal for the next week
(store 2 again), 20% switch to store 1. What will be the proportion of customers shopping at
store 1 and 2
a) In each of the next two weeks?
b) In the long run?
Let’s denote Store 1 by X and Store 2 by Y.
V0= (0.8 0.2) - initial state/ current state matrix.V0 denotes Current week.
To the next week shopping period (transition Probability)
X Y

X 0.9 0.1

Y 0.2 0.8

 The sum of rows in the transition matrices should be one.

 We have to be consistent in writing the elements.
N.B P11, P22, P33, P44 ---------------------Pnn that represent the primary diagonal show loyalty.
Others show switching.
Markov Chain Formula
nth state of a Markov Chain.
V (n) = V (n-1) x p, or V (n) = V (0) x (P) n.
Or
V (n) = V (0) x (P) n.
Where: P = transition Probability
V (n) = state probability for period n.
V (n-1) = state probability for period n-1.

V (0) = (.8 .2)

V (1) = V (0) x P
 .9 .1
 
= (.8 .2) 
 .2

.8
 

= (.8 x .9) + (.2x.2) (.8x.1) + (.2x.8)

= .72 + .04 .08 +. 16
= 0.76 = 0 .24

Vxy(1) = (.76 .24)

Vxy(2) = Vxy(1) x P
 .9 .1
 
= (.76) .24) 
 .2

.8
= (0.732 0.268)
 

B. In the long run (V1 V2) (n) = (V1 V2) (n+1)

Chapter Two: Matrix Algebra and its Applications Page 12

 Mathematics for finance Deprtment of Accounting and Finance

n p n+1
 .9 .1
 
(V1 V2) 
 .2

.8
= (V1 V2)
 

0.9V1 + .2V2 = V1
.1V1 + .8V2 = V2
V1 + V2 = 1
-.1V1 + .2V2 = 0 
 one is the - ve of the other.
.1V1 + -.2V2 = 0 

.9V1+.2(1-V1) =V1
.9V1 + .2 - .2V1 = V1
.7V1 + .2 = V1
.2 = .3V1
V1 = 2/3
V2 = 1 - V1
= 1 - 2/3
V2 = 1/3

In short, the switching over the sum of the switching gives us the long run state.

To

S1 S2

From S1 .9 .1

S2 .2 .8

V1= V2 =

= =

2 1
(V1 V2) =  
3 3

In the long run 67% of the customer will shop in store 1 and 33% in store 2.
Prediction: Long run - only the transition matrix.
At specified time - the transition matrix and state vector.
Hence, unless the transition matrix is affected, the long run state will not be affected.
Moreover, we cannot know the number of years, weeks, or periods to attain the long run
state, point but we can know the share.

Absorbing Markov Chain

It is a special type of Markov chain in which at least one of the states eventually doesn’t lose
members. We call such a state absorbing because it can absorb members from other states,
but doesn’t give up any of its members.
For example, if we take the above example and change the transition matrix

Chapter Two: Matrix Algebra and its Applications Page 13

 Mathematics for finance Deprtment of Accounting and Finance

S1 S2
S1 1 0
S2 .2 .8
The state S1 (store 1) in absorbing

In short:
Consider a Markov chain with n different states {S1, S2, and S3 --- Sn}.
The ith state Si is called absorbing if Pii = 1. Moreover, the Markov chain is called absorbing
if it has at least one absorbing state, and it is possible for a member of population to move
from any non-absorbing state to an absorbing one in a finite number of transitions.

Remark: Note that for an absorbing state Si, the entry on the main diagonal p must be P ii = 1
and all other entries in the ith row must be 0.

E.g. a.

E.g. b.

Chapter Two: Matrix Algebra and its Applications Page 14

 Mathematics for finance Deprtment of Accounting and Finance

S1 .5 1 5 0 0 
 
fro m  S 2
 0 1 0 0
The second state is absorbing. However
0 0 .4 6 
S3 
S 4 0 0 5 .5 
the corresponding Markov chain is not absorbing. Because there is no way to move from
state 3 or state 4 to state 2.

A Markov chain is absorbing if it has at least one absorbing state, and if from every state it is
possible to go to an absorbing state (not necessarily in one step).

Chapter Two: Matrix Algebra and its Applications Page 15