1
$\begingroup$

One of the applications of Principal Component Analysis in Finance is to analyse the shape of the yield curve.

But what conclusions can be drawn exactly from performing this exercise? Does it help us to build a better yield curve? How are we able to better manage risk if we do it?

$\endgroup$
4
$\begingroup$

You can see my remark above for some more words on PCA for the yield curve and an interesting paper. About the question whether it helps us to creat a risk model: PCA on the yield curve changes (!) tells us:

  • what are dominant moves (it turn out it is a pralell-shift, steepening and curvature change)? This gives us a picture and language to think and speak about yield curve changes. Recall those structured products that were sold before 2008 and mabye some still are sold: steepeners and such.
  • this moves are uncorrelated. Thus is makes sense to think of the current yield curve and then of scenarios when uncorrelated changes act on it. You might want to have this invariant element in your model.

These are the main points: uncorrelated shape changes.

$\endgroup$

Your Answer

By clicking "Post Your Answer", you acknowledge that you have read our updated terms of service, privacy policy and cookie policy, and that your continued use of the website is subject to these policies.

Not the answer you're looking for? Browse other questions tagged or ask your own question.