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Chapter 2: Estimating the Term Structure

2.4 Principal Component Analysis

Interest Rate Models


Damir Filipovic
2.4 Principal Component Analysis

Major problem in term structure


estimation: high dimensionality
Aim: find basis shapes of the yield
curve (increments)
Principal component analysis (PCA):
dimension reduction technique in
multivariate data analysis

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Spectral Theorem

Key mathematical principle underlying PCA:

Spectral theorem: Any real symmetric n n matrix Q can be decomposed

Q = ALA>

where
L is the diagonal matrix of eigenvalues 1 2 n of Q;
A is an orthogonal matrix whose columns a1 , . . . , an are the normalized
eigenvectors of Q (Qai = i ai ), which form an orthonormal basis of Rn .

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Spectral Decomposition of Covariance Matrix

Let X be an n-dimensional random X2


vector with
a2
mean = E[X ]
covariance matrix Q = cov[X ] a1
(symmetric and positive semi-definite)
Spectral theorem: Q = ALA> with
eigenvalues 1 n 0 0 X1
eigenvectors a1 , . . . , an

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Principal Components and Loadings of X

The principal component transform of X


is given by recentering and rotation X2
>
Y = A (X )
a2
where
a1
Yi = ai> (X ) is the ith principal

component of X
ai is the ith vector of loadings of X
0 X1
Principal component decomposition

X = + AY = + ni=1 Yi ai
P

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Properties of the Principal Components

The principal components Y are uncorrelated and have variances Var[Yi ] = i :

E[Y ] = 0
Cov[Y ] = A> QA = A> ALA> A = L

Y1 has maximal variance among all standardized linear combinations of X :

Var[a1> X ] = max Var[b > X ] | b > b = 1




For i = 2, . . . , n: Yi has maximal variance among all such linear combinations


orthogonal to first i 1 linear combinations

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Explained Variance

Observe that
n
X n
X n
X
Var[Xi ] = trace(Q) = i = Var[Yi ]
i=1 i=1 i=1

Hence the amount of variability in X explained by the first k principal


components Y1 , . . . , Yk is given by
Pk

Pni=1 i .
i=1 i

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Application

Let X be n-dimensional stationary model for (daily changes of) the yield curve.

If the first k  n principal components Y1 , . . . , Yk explain a significant amount


of variability in X then approximate
k
X
X + Yi ai .
i=1

Loadings a1 , . . . , ak are main components of stochastic yield curve movements.

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Sample Principal Components

Assume multivariate data observations x = [x(1), . . . , x(N)] where each column


x(t) = (x1 (t), . . . , xn (t))> is a sample realization of a random vector X (t).

Assume X (t) is identically distributed as X with


mean = E[X ]
covariance matrix Q = cov[X ]

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Empirical Mean and Covariance

Estimate by the empirical mean


1
PN
= N t=1 x(t)

and Q by the empirical n n covariance matrix (positive semi-definite)

Qij = Cov[xi , xj ] = N1 Nt=1 (xi (t) i )(xj (t) j ).


P

Spectral theorem: Q = ALA> with


eigenvalues 1 n 0
eigenvectors a1 , . . . , an

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Sample Principal Components

The sample principal component decomposition of x is given by

x = + ni=1 yi ai
P

with
empirical principal components y = A> (x )
loadings A = [a1 | | an ].

The empirical principal components are uncorrelated:


N
(
1 X i , if i = j,
Cov[yi , yj ] = yi (t)yj (t) =
N t=1 0, else

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Discussion

The empirical mean and covariance matrix Q are standard estimators for the
true parameters and Q, if observations X (t) are serially uncorrelated,

Cov[X (t), X (t + h)] = 0 for all h 6= 0.

If this kind of stationarity of time series X (t) is in doubt, the standard practice is
to differentiate and to consider the increments

X (t) = X (t) X (t 1).

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PCA of the Yield Curve

Example: monthly changes (t = 1/12) of the yield curve

xi (t) = y (t + t; t + t + i ) y (t, t + i )

of Swiss government bonds from August 2005 until July 2015 for n = 8 times to
maturities i = 2y, 3y, 4y, 5y, 7y, 10y, 20y, 30y.

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Yield Curve Loadings

First three yield curve loadings:


Level Slope Curvature
0.6
1st loading is roughly flat: parallel
0.4
shifts of the yield curve (level).
0.2
2nd loading is upward sloping: tilting

Loading
0
of the yield curve (slope).
-0.2
3rd loading is hump-shaped: flexing
-0.4
of the yield curve (curvature).
-0.6
0 5 10 15 20 25 30
Time to maturity

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Explained Variance of Principal Components

Explained variance of the principal components:


PC Explained variance (%)
1 76.97
2 18.39
3 3.25
sum 98.61

The first three principal components explain more than 98% of the variance.
Consequence: yield curve (movements) can be approximated by linear
combination of first three loadings, with small relative error.

Interest Rate Models

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