· r-2

R: Markov Chain Wikipedia Example

Over the weekend I've been reading about Markov Chains and I thought it'd be an interesting exercise for me to translate Wikipedia's example into R code.

But first a definition:

A Markov chain is a random process that undergoes transitions from one state to another on a state space. It is required to possess a property that is usually characterized as "memoryless": the probability distribution of the next state depends only on the current state and not on the sequence of events that preceded it.

that 'random process' could be moves in a Monopoly game, the next word in a sentence or, as in Wikipedia's example, the next state of the Stock Market.

The diagram below shows the probabilities of transitioning between the various states:

800px Finance Markov chain example state space svg

e.g. if we're in a Bull Market the probability of the state of the market next week being a Bull Market is 0.9, a Bear Market is 0.075 and a Stagnant Market is 0.025.

We can model the various transition probabilities as a matrix:


M = matrix(c(0.9, 0.075, 0.025, 0.15, 0.8, 0.05, 0.25, 0.25, 0.5),
          nrow = 3,
          ncol = 3,
          byrow = TRUE)

> M
     [,1]  [,2]  [,3]
[1,] 0.90 0.075 0.025
[2,] 0.15 0.800 0.050
[3,] 0.25 0.250 0.500

Rows/Cols 1-3 are Bull, Bear, Stagnant respectively.

Now let's say we start with a Bear market and want to find the probability of each state in 3 weeks time.

We can do this is by multiplying our probability/transition matrix by itself 3 times and then multiplying the result by a vector representing the initial Bear market state.


threeIterations = (M %*% M %*% M)

> threeIterations
> threeIterations
       [,1]    [,2]    [,3]
[1,] 0.7745 0.17875 0.04675
[2,] 0.3575 0.56825 0.07425
[3,] 0.4675 0.37125 0.16125

> c(0,1,0) %*% threeIterations
       [,1]    [,2]    [,3]
[1,] 0.3575 0.56825 0.07425

So we have a 56.825% chance of still being in a Bear Market, 35.75% chance that we're now in a Bull Market and only a 7.425% chance of being in a stagnant market.

I found it a bit annoying having to type '%*% M' multiple times but luckily the expm library allows us to apply a Matrix power operation:


install.packages("expm")
library(expm)

> M %^% 3
       [,1]    [,2]    [,3]
[1,] 0.7745 0.17875 0.04675
[2,] 0.3575 0.56825 0.07425
[3,] 0.4675 0.37125 0.16125

The nice thing about this function is that we can now easily see where the stock market will trend towards over a large number of weeks:


> M %^% 100
      [,1]   [,2]   [,3]
[1,] 0.625 0.3125 0.0625
[2,] 0.625 0.3125 0.0625
[3,] 0.625 0.3125 0.0625

i.e. 62.5% of weeks we will be in a bull market, 31.25% of weeks will be in a bear market and 6.25% of weeks will be stagnant,

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