Mat-2.

108 Independent Research Project in Applied Mathematics

November 15, 2006

Principal Component Analysis on Term Structure of Interest

Rates

Helsinki University of Technology

Systems Analysis Laboratory
Antti Malava 64705M
Department of Engineering Physics and Mathematics

1.

Introduction..............................................................................................................................1

2.

Principal Component Analysis.................................................................................................1

3.

4.

5.

2.1

Mathematical formulation................................................................................................2

2.2

Choosing the number of Principal Components ..............................................................6

2.3

Interpretation of Analysis.................................................................................................6

2.4

Geometrical Interpretation ...............................................................................................7

2.5

Discussion ........................................................................................................................8

Modelling Term Structure of Interest Rates with PCA............................................................8

3.1

Term Structure .................................................................................................................8

3.2

Literature Review of Principal Component Analysis on Term Structure........................9

3.3

Applications in Finance .................................................................................................10

Implementation and Results...................................................................................................13

4.1

Data Preparation.............................................................................................................13

4.2

Preliminary Analysis......................................................................................................14

4.3

Problem Formulation .....................................................................................................16

4.4

Individual Currency Zone Results .................................................................................16

4.5

Combined Currency Zone Results .................................................................................21

Conclusions and Discussion ..................................................................................................24

References......................................................................................................................................25

1. Introduction
Term structure of interest rates has for long posed interesting challenges with regards to modelling,
explaining and predicting its behaviour. However, analysing term structure often involves dealing
with huge data sets that may cause the calculation processes to become slow and cumbersome and
the results difficult to be interpreted and used in further applications. On the other hand, interest
rates of different maturities exhibit distinguishable common behaviour. Therefore it may be very
useful to simplify the data or the data structure by identifying factors of common behaviour such
that not much of the contained information is lost.
This paper introduces principal component analysis (hereafter referred to as PCA) as a powerful
tool of identifying patterns in data of high dimension. PCA is a statistical technique in which the
original variables are replaced by a smaller number of artificial variables that preserve as much as
possible of the variability of the original variables. There are two objectives of data simplification:
to reduce the number of variables and to detect a structure in the relationships between variables.
The paper discusses PCA with focus on constructing a market model for different currency zones
term structures of interest rates. PCA is applied to four interest rate curves, namely EUR, USD, JPY
and GBP curves including both short and long term interest rates. Two different approaches are
compared: performing PCA separately for each curve and performing one PCA for all curves
combined. With regards to interest rates, the markets typically show three distinct patterns that are
represented by first three principal components (hereafter referred to as PCs): level or shift,
slope or twist and curvature or bow.
The rest of this paper is structured as follows. Section 2 presents the methodology of standard PCA
in detail. Section 3 introduces term structure of interest rates, presents some of the PCA modelling
performed on it in literature and discusses cases where it may be useful to apply PCA. In section 4,
PCA is performed on term structure and the results are analysed. Finally, section 5 draws together
conclusions and discussion arisen from the study.

2. Principal Component Analysis

PCA is a statistical technique for simplifying a set of data. The key idea of PCA is to perform a
linear transformation of the original data to a new orthogonal coordinate system such that that axes
are ordered in terms of the amount of variance in a dataset. In other words, the greatest variance by
any projection of the original data set comes to lie on the first axis called the first PC, the second
greatest variance on the second axis, and so on. PCA therefore finds the true dimensionality of the
data set by compressing correlations in the data to single variables. Figure 1 illustrates the
transformation graphically for two-dimensional data. The obvious distinction to other linear
transformations is that PCAs basis vectors are not fixed but depend on the data set.
1

X2

1. PC

X1
2. PC

Figure 1. Geometrical representation of PCA

The linear transformation allows describing the original data set exactly by the uncorrelated
artificial variables called principal components that are ordered with decreasing explanatory power.
However, the real purpose of PCA is to select those PCs that explain the variability of the data to a
required degree and accuracy. This allows considerably reduction in the dimension of variables,
which in turn simplifies calculation processes.
PCA is often discussed with relation to factor analysis. However, although these two methods are
similar statistical tools, they differ in the methodologies employed and the focus of the analysis.
While PCA attempts to find a series of independent linear combinations of the original variables
that provide the best possible explanation of diagonal terms of the matrix analysed, factor analyses
focuses on the off-diagonal elements of the correlation matrix (Jorion, 2002). What this means is
that PCA is not based on any particular statistical model whereas factor analysis is.

2.1 Mathematical formulation

The following mathematical formulation of PCA is mainly based on Mellin (2004).
Consider a set of n variables x1, , xn as a random vector x with zero empirical mean and
nonsingular covariance matrix S:
E (x) = 0
Cov (x) = 0

1st Principal Component

The objective is to find the linear combination of random variables x1, , xn that contains as much
of the variability of the random variables x1,,xn as possible. In other words, for a linear
combination
n

T x = i xi
i =1

maximize its variance

D 2 ( T x)
subject to

= T = 1

Vector b is a weight vector that tells us by what weight does each of the variables xj affect the
variance of the linear combination T x . The condition

= T = 1

is a norming condition.
It can be shown that that
max D 2 ( T x) = 1T 1 = 1

T =1

where
l1 = largest eigenvalue of the covariance matrix S

1 = eigenvector corresponding to the largest eigenvalue of the covariance matrix S

Therefore the 1st principal component is
y1 = 1T x

2nd Principal Component

The next step is to find the linear combination of random variables x1, , xn that is uncorrelated
with the 1st principal component and contains as much of the variability of the random variables
x1,, xn as possible. In other words, for the linear combination
n

T x = i xi
i =1

maximize its variance

D 2 ( T x)
subject to

= T = 1

and
Cov( y1 , T x) = 0
Again it can be shown that
max

T =1
Cov ( y1 , T x ) = 0

D 2 ( T x) = T2 2 = 2

where
l2 = second largest eigenvalue of the covariance matrix S

2 = eigenvector corresponding to the second largest eigenvalue of the covariance matrix S

Therefore the 2nd principal component is
y 2 = T2 x

Remaining Principal Components

Continuing the same way produces all n linear combinations of x with the following properties:

The variance of the linear combinations is the largest possible

The linear combination is uncorrelated with the previously identified linear combinations

These linear combinations form the principal components of random vector x.

From above it is trivial that the principal components are obtained from the eigenvalue
decomposition of the covariance matrix S:
= BDB T
in which
D = diag (1 , 2 ,..., n )
is the diagonal matrix composed of the eigenvalues
1 2 ... n
of the covariance matrix S, and the matrix

B = [ 1 M 2 M ...M n ]
is an orthogonal matrix
B T B = BB T = I
consisting of the corresponding eigenvectors as its columns.
Therefore the principal components can be expressed as
y i = Ti x = 1i x1 + K + Ni x N

representing the i.th principal component, i = 1, 2, , n

The eigenvectors with the largest eigenvalues correspond to the dimensions that have the strongest
correlation in the dataset. This means that the more correlated the data, the bigger share of the total
variation is explained by the first principal component.
After finding the PCs, we can express the original variables as a linear combination of principal
components:
xi = i y = Bi1 y1 + K + iN y N

2.2 Choosing the number of Principal Components

There is no single criterion against which the number of useful principal components can be
evaluated, because the explanatory power of the principal components can differ arbitrarily from
case to case. However, a couple of basic rules are often employed. Threshold criterion guides to
select as many PCs as is necessary (i.e. the first K PCs) for the cumulative explanatory degree to
exceed certain percentage, such as 90% (e.g., Kreinin et al., 1998.):
K

i =1
N
i =1

> Threshold

Another criterion first sorts the eigenvalues in order of magnitude, then finds from the spectrum a
break point that divides the eigenvalues in large and small and finally chooses the PCs
corresponding to the large eigenvalues (Mellin, 2004).
If the original variables are standardized for PCA (see section 2.5), each of them will have a unit
variance. Therefore any PC with an eigenvalue of at least 1 explains more of the total variance than
any of the original variables. Thus a simple heuristic would be select those PCs that have an
eigenvalue of at least 1 (Clustan, 2006).
Deciding to keep only the first r PCs allows us to replace the previous exact relationship by a close
approximation:
xi i y = Bi1 y1 + K + ir y r

2.3 Interpretation of Analysis

The computed eigenvalues represent the variance of each PC, while the eigenvectors are their
loadings.
We can compute an n x r -principal component matrix, also referred to as factor structure :
Fr =

1 1 M 2 2 MLM r r

= B r D 1/2
r

where

B r = [ 1 M 2 MLM r ]

D1/2
1 , 2 ,K, r
r = diag

)
6

If PCs are calculated from standardized data (that is, from the correlation matrix), the PC matrix
elements represent the correlation between the r chosen PCs and the n original variables.
We can also compute principal component scores that represent the value of each PC with respect
to each observation:
y j = B r x j , j = 1,2,..., n

where the i.th component

y ji , i = 1,2,..., r

of r-vector
y j = ( y j1 , y j 2 ,..., y jr )

is thus the value of i.th principal component yi at observation j=1,2,,n, i=1,2,,r

2.4 Geometrical Interpretation

The geometric interpretation of principal component analysis is the following. The j-dimensional
linear subspace spanned by the first j principal components gives the best possible fit to the data
points as measured by the sum of squared perpendicular distances from each data point to the
subspace. In other words, let
x = (x1, x2, , xn)
be a random vector for which the following holds:
E (x) = 0
Cov (x) = 0

Quadratic form expression

f (x) = x T 1 x = c
where c is a constant determines an ellipsoid of n-dimensional space as a function of variable x. It
can be shown that the principal components are the main axis of the ellipsoid
x T 1 Bx = c

The main axis of the ellipsoid coincide with the directions of the eigenvectors of the covariance
matrix S and the lengths of the main axis relate to each other as numbers
7

i
where li is the ith eigenvalue of the covariance matrix S. The geometric interpretation is illustrated
in figure 1, where all principal component vectors are drawn for 2-dimensional data.

2.5 Discussion
Although PCA appears to have many benefits, few things should be kept in mind when considering
performing PCA to a particular data set. Firstly, PCA is not a statistical method from the viewpoint
that there is no probability distribution specified for the observations. Therefore it is important to
keep in mind that PCA best serves to represent data in simpler, reduced form.
Another challenge to be kept in mind is that it is often difficult, if not impossible, to discover the
true economic interpretation of PCs since the new variables are linear combinations of the original
variables.
In addition, for PCA to work exactly, one should use standardized data so that the mean is zero and
the unbiased estimate of variance is unity:

zi =

xi x

where
zi = i.th standardized variable
This is because it is often the case that the scales of the original variables are not comparable and
that (those) variable (variables) with high absolute variance will dominate the first principal
component.
There is one major drawback to standardization, however. Standardizing means that PCA results
will come out with respect to standardized variables. This makes the interpretation and further
applications of PCA results even more difficult.

3. Modelling Term Structure of Interest Rates with PCA

3.1 Term Structure
Term structure of interest rates, one of the most followed curves in money and capital markets,
describes the time structure of cost of borrowing (or required rate of return). More specifically, term
structure tells the market cost of borrowing (or required rate of return) for zero-coupon bonds of
different maturities, i.e. the rate of return required by market for periods of different length.
8

Term structures are calculated for different classes of bonds, most typically for risk free government
bonds. The most important and widely used interest rates, however, consist of Interbank Offered
Rates and swap rates that derive from high credit rating banks borrowing money from each other.
These curves typically lie a little higher than government curves.
There are numerous, ongoing challenges offered by the term structure: how to estimate it, how to
use it to evaluate implicit interest rates in future (forward rates) and how to explain the shape and
the movements of the curve, the most demanding challenge.

3.2 Literature Review of Principal Component Analysis on Term Structure

There are numerous examples in literature of PCA performed on interest rates with different setups
and focuses. PCA has been applied to short term (money market) and long term (capital markets)
interest rates separately, and on all maturities combined (for example, Heidari et al., 2000). Some
research has not only considered interest rates but has combined data from equities, foreign
exchange (FX) and interest rates markets (for example, Loretan, 1997). In addition, PCA has been
performed to not only levels and differences but also to derivative features of interest rates such as
option volatility surfaces (for example, Cont et al, 2002).
Even though the setups of the PCAs on interest rates in literature vary quite extensively, the results
and conclusions, perhaps little surprisingly, are similar. It seems, in general, that interest rates levels
and differences can be explained with first three PCs to a sufficient extent. Similarly, there is scope
for significant dimension reduction when combining data from equity, exchange rates and interest
rates (Loretan, 1997).
Considering interest rate derivatives features, such as option volatility surfaces, some studies have
identified the need for additional PCs (independent volatility factors) in order to explain the
variability of the surface (Heidari & Wu, 2001) while other similar studies have coped with
standard three PCs (Cont et al). The reason why implied volatilities or credit spreads are more
challenging to estimate in sufficient magnitude and accuracy with few PCs derives from their
nonlinear nature (Frye 1998).
In addition, it is noteworthy that the quality and the focus of research vary extensively. While some
papers concentrate on presenting the results, they overlook the real interpretation of PCA and do not
take into account the limitations of PCA. In addition, the usability of PCA results is highly
dependant on the choice of setup of analysis. For example, choosing to perform PCA on levels
rather than differences forgoes the opportunity to construct meaningful and informative market
scenarios that for many end users might be the real value of PCA. Continuing the same argument,
standard PC selection criteria does not work effectively for all cases (Kreinin et al, 1998),
discussion of which is often bypassed.

3.3 Applications in Finance

Simpler and Faster VaR Processes

PCA is often used in the field of portfolio risk management to reduce the dimensionality of the risk
factor space (Loretan, 1997). Since a large share of positions held by market participants is interest
rate related derivatives, modelling term structure of interest rates, or different yield curves, with
PCA may result in significant simplification of risk models. Instruments not related to interest rates,
such as common stocks, have also successfully been modelled with PCA.
The risk of asset portfolios is typically measured as Value at Risk (VaR)1:
VaR measures the worst expected loss over a given horizon under normal market conditions at a
given confidence level (Jorion, 2004).
VaR can be defined in many forms. For example, relative VaR is defined as the loss in currency
units relative to the mean, i.e. to the expected value:
VaR MEAN = E (W ) W * = W0 ( R * )

where
E(W) = expected value of the portfolio at the end of the target horizon
W * = lowest portfolio value at the given confidence level
W0 = initial investment
R * = lowest portfolio return at the given confidence level
From the above definition, it is easy to compute for example parametric VaR as

VaRMEAN = W0 t
where
= standard normal deviate corresponding to desired left-tail confidence level
= standard deviation of portfolio return

A thorough discussion of VaR -methodology itself is beyond the scope of this study. A reader interested to explore the
field of VaR is referred to a comprehensive guide to VaR by Philippe Jorion (Jorion, 2004).

10

t = time adjustment factor

It is obvious that correlations are essential driving forces behind portfolio risk (Jorion, 2004).
However, the number of correlations increases geometrically with the number of assets (figure 2):
with n assets, the number of correlations is n * ( n + 1) / 2 .
corrs Number of correlationsas a function of number of assets
20000

15000

10000

5000

assets
50

100

150

200

Figure 2. Number of correlations as a function of number of assets in a portfolio

This poses two problems with large portfolios. Firstly, when the number of assets increases, it is
more likely that some correlations will be measured inaccurately or incorrectly. Secondly, the
computation time of covariance matrix and the subsequent VaR calculations can increase
dramatically, which is not feasible for making quick decisions on trading portfolio positions in fastchanging markets. Thirdly, the VaR of the portfolio may not be positive2.
The benefit of performing PCA is that to examine the behaviour of original variables we can
simulate the movements of principal components. Not only is the number of PCs much smaller but
also the covariance matrix is positive definite, because the eigenvalue decomposition produces
uncorrelated variables.
Consider a portfolio z = wR mapped into its exposures on the first K principal components:

VaR is proportional to portfolio variance, which is positive only if the covariance matrix is positive definite. This
requires the number of observations to be larger than the number of variables, and the series cannot be linearly
correlated. The problem of positive-definiteness occurs more likely when portfolio consists of a large number of highly
correlated assets such as zero-coupon bonds.

11

z = wi Ri w1 ( 11 y1 + ... + 1K y K ) + ... + wN ( N 1 y1 + ... + NK y K )

= ( w1 11 + ... + wN N 1 ) y1 + ... + ( w1 1K + ... + wN NK ) y K
= 1 y1 + ... + K y K
where
i = w T i represents the weighted exposure to i:th principal component

Furthermore, the variance of the portfolio can be computed easily:

2 (z ) = * = w T 1 1T w 1 + ... + w T K TK w K
= (w T 1 ) 2 1 + ... + (w T K ) 2 K
= 12 2 ( y1 ) + ... + K2 2 ( y K )

In other words, the variance of the portfolio z is given by sum of the squared exposures times the
variance of each PC. This is a remarkable simplification compared to the variance calculated with
original variables because instead of requiring all of the variances and covariances of the original
variables, it is enough to use K independent variables. In other words, for a portfolio of m variables
the covariance matrix of dimension m*m can be replaced with just a few variables.
However, it is not difficult to construct a portfolio which has a large position sensitive to risk
factors that appears unimportant in the PCA (Kreinin et al., 1998). This means that to perform
efficient PCA on a portfolio, one should select the PCs not based on how much they explain of the
total variability of the data but on how much of the variability of the particular portfolio. For
example Hull (2005) presents a portfolio that has little exposure to the first component but
significant exposure to the second component (calculated for U.S. Treasury data). Using only one
component to hedge the position, which is similar to duration-based hedging that considers a
parallel shift in term structure, would dangerously understate VaR. This important remark is
surprisingly often not mentioned in literature regarding principal component analysis.

More Efficient Hedging Strategies

In financial analysis duration, the first derivative of interest rate related assets price function with
respect to the interest rate, is a basic but extensively employed tool for hedging, that is, for trying to
insure that (small) changes in interest rates will not cause the value of an investment portfolio (of
fixed-income securities) to fluctuate significantly. However, relying on simple duration is over
simplistic because the changes in interest rate levels are not always parallel shifts, in which case
zero-duration portfolio will not be immunised.
Identifying first few principal components allows achieving a better-hedged position because the
components explain almost all of the return variability across the whole spectrum of maturities
12

(Litterman et al, 1991). Given the simple computation of portfolio returns and variance, it is easy to
create portfolios that are immune to a factor by selecting asset holdings that make the sensitivity of
the portfolio equal to zero.

Macroeconomic Analysis
Empirical research in literature suggests that although PCA produces artificial variables that explain
the variability of interest rates, one can associate rational macroeconomic interpretations to these
variables (Wu, 2003). For example, there is tendency for strong correlation between surprises of
monetary policy and the subsequent movement of the slope component. This area of study is vital
among central bankers and agents involved in and directly affected by central bank actions.
In addition, PCA overcomes some computational problems often confronted in macroeconomic
analysis. Typical macroeconomic models try to explain or predict variations in response variables
by variations in prediction variables trough, for example, Multiple Linear Regression (MLR).
However, macroeconomic variables often tend to be somewhat linearly dependent which leads to
problems of multicollinearity. PCA resolves this problem by creating uncorrelated variables on
which the original response variables can be regressed. The methodology of combining PCA with
MLR is called Principal Component Regression.

4. Implementation and Results

In this section, PCA is applied to the term structure of interest rates of four different currency zones:
Eurozone (EUR), United States (USD), Japan (JPY) and Great Britain (GBP). The motivation
makes it possible to examine and describe different currency zone interest rate structures with a
few-factor model, and see whether global term structure movements can be explained by a set of
relatively few common factors. In addition, combining short term and long term interest rates
allows seeing if, how and why money markets (and thus money market instruments) behave
differently from markets of longer maturities.

4.1 Data Preparation

The data used represents first differences of daily last quotes of Interbank Offered Rates (Euribor
for EUR and Libor for USD, JPY and GBP) for money market data and interest rate swap rates of
each currency zone. Time series of 3 months is used, from 7/4/2006 to 7/7/2006, gathered from
Bloomberg.
The choice of Interbank Offered rates and swap rates is based on the previously stated fact that they
are the widest used rates in financial and capital markets. In addition, these rates do not have the
problem of demand and supply that might distort the informational content of the data (Heidari et
al, 2000). The chosen currency zones represent large part of most influential economic zones in the
world.
13

In the cases studied in this paper, all of the variables represent interest rates with variances of
comparable magnitude. Evidence suggests that with such variables standardized and nonstandardized data produce very similar results (Rodrigues, 1997). Therefore we have not
standardized the data (except for the mean) to facilitate the interpretation of the results. Analysing
first differences, rather than levels, has the advantage that it allows constructing different interest
rate curve scenarios that are often very useful considering applications of PCA. The disadvantage,
however, is that taking first differences has a tendency to artificially increase noise and therefore
decrease the efficiency of estimation (Heidari et al., 2002).
I performed PCA on two different setups. Firstly, I analysed each currency zone term structures
independently and compared the correlations between PCs specific to different currency zones. In
the second setup I performed one aggregate analysis.

4.2 Preliminary Analysis

During the observation period the general trend of EUR interest rates was slightly upwards (figure
3). It can be seen that long-term interest rates behave very much in accordance with each other, but
money market rates (and thus money market instruments) exhibit slightly different characteristics.
This suggests that it is likely to find a rather well explaining EUR market model based on a few
PCs, although money market rates need special considerations.
Similar behaviour can be distinguished in and USD and JPY interest rates during the observation
period. Two differences, however, exists. Firstly, USD interest rates curve exhibit a small twist at
the boundary of money market so that 2Y, 3Y and 4Y swap rates are actually at lower level than
12M Libor in the middle of the observation period. This hints about expectations of market
participants about near future development of interest rates and thus the monetary policy moves.
Secondly, JPY interest rates are at very low level with short rates almost at zero. Long rates are
much higher implying that contractionary monetary policy actions are expected in the near future3.
While the general trend of GBP interest rates development over the observation period is similar to
EUR and USD rates, the GBP interest rate curve looks quite different to them. Short GBP interest
rates are significantly lower than medium term interest rates, which in turn are higher than long
interest rates, thereby forming a hump-shaped curve. This indicates that monetary policy, future
expectations and even economic situation were quite different in UK when compared to other
currency zones analysed during the observation period.

In fact, on 14th July 2006, during the writing of this paper and slightly after the end of the observation period used,
Bank of Japan ended its 6-year period of effectively zero interest rates by raising the key interest rate to 0.25%.

14

EUR Interest Rates Development

EUR Interest Rates, 23.5.2006

6M

12M

4,50

2Y

4,5

3Y

4,10

4Y

Percent

Interest Rate (%)

1M

3M

4,90

5Y

3,70

6Y

7Y

3,30

8Y

9Y

2,90

4
3,5
3
2,5

10Y

1M

3Y
4Y

6Y

8Y

5,30
5,20
5,10
5,00
4,90
4,80
4,70
4,60
4,50
4,40
4,30

25
Y
30
Y

20
Y

12
Y
15
Y

9Y
10
Y

8Y

7Y

6Y

Y
30

Y
25

Y
15

20

Y
12

10

9Y

8Y

7Y

6Y

5Y

20Y
25Y

4Y

15Y

1M

7.
4.
2
14 006
.4
.2
21 006
.4
.2
28 006
.4
.2
0
5. 06
5.
20
12
0
.5 6
.2
19 006
.5
.2
26 006
.5
.2
0
2. 06
6.
20
9. 06
6.
2
16 006
.6
.2
23 006
.6
.2
30 006
.6
.2
0
7. 06
7.
20
06

Maturity

30Y

1M

GBP Interest Rates, 23.5.2006

3M

6M

12M

2Y

3Y

4Y

Percent

5Y

6Y

7Y

8Y

9Y

10Y

12Y

JPY Interest Rates Development

3,50

25Y

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

8Y

7Y

6Y

5Y

4Y

3Y

2Y

M
12

20Y

6M

15Y

3M

06 .06 .06 .06 .06 .06 .06 .06 .06 .06 .06 .06 .06
5
6
5
5
6
6
4
4
4
6
6
5
4.
9. 16. 23. 30.
2.
5. 12. 19. 26.
7. 14. 21. 28.
Date

5,20
5,10
5,00
4,90
4,80
4,70
4,60
4,50
4,40
4,30
4,20

1M

Interes Rate (%)

4,90
4,80

12Y

GBP Interest Rates Development

5Y

5,10
5,00

9Y
10Y

2Y

7Y

3Y

5,20

5,40

5Y

Percent

Interest Rate (%)

12M

5,80
5,70
5,60
5,50
5,40
5,30
5,20

6M

2Y

Date

4Y

USD Interest Rates, 23.5.2006

3M

5,80

4,80

3Y

Maturity

30Y

6M

5,00

2Y

25Y

6,00

5,60

6M
12
M

20Y

12

USD Interest Rates Development

1M

7.
4.
2
14 00
.4 6
.2
21 006
.4
.2
28 00
.4 6
.2
0
5. 06
5.
20
12
0
.5 6
.2
19 00
.5 6
.2
26 006
.5
.2
0
2. 06
6.
20
9. 06
6.
2
16 00
.6 6
.2
23 00
.6 6
.2
30 006
.6
.2
0
7. 06
7.
20
06

Date

15Y

3M

12Y

3M

2,50

Maturity

30Y

JPY Interest Rates, 23.5.2006

1M
3M
6M

3,00

3,00
2,50

2Y
3Y

2,00

2,00

4Y

1,50

Percent

Interest Rate (%)

12M

2,50

5Y
6Y

1,00

7Y
8Y

0,50

9Y

0,00

10Y

-0,50

12Y

1,50
1,00
0,50
0,00

Date

Maturity

30Y

Figure 3. Graphical representation of the raw data used in analysis.

15

Y
30

Y
25

Y
15

20

Y
10

12

9Y

8Y

7Y

6Y

5Y

4Y

2Y

3Y

6M

25Y

12

20Y

3M

1M

7.
4.
06
14
.4
.0
6
21
.4
.0
6
28
.4
.0
6
5.
5.
06
12
.5
.0
6
19
.5
.0
6
26
.5
.0
6
2.
6.
06
9.
6.
06
16
.6
.0
6
23
.6
.0
6
30
.6
.0
6
7.
7.
06

15Y

4.3 Problem Formulation

Considering each currency zone separately, let x = (x1, x2,, x18) be a vector of the 18 zero-mean
random variables representing absolute daily changes of interest rates of each maturity and let S be
the corresponding covariance matrix. Performing eigenvalue decomposition
= BDB T
yields 18 eigenvectors
B = [ 1 M 2 MLM 18 ]
and 18 eigenvalues
D = (1 , 2 ,..., 18 ) T

We get 18 principal components

T
y1 = 1T x,..., y18 = 18
x

that explain completely the variability of the original variables. The aim is to be able to explain at
least 90% of the total variability of interest rates across the term structure with as few PCs as
possible for each currency zone. In order to determine how many PCs are sufficient, we need to
analyse the explanatory power of them.
Similar analysis is conducted for aggregate data with 4 (currency zones) * 12 (maturities) variables
x = (x1, x2,, x72) and corresponding 72 principal components.

4.4 Individual Currency Zone Results

Explanatory Power of PCs

Figure 4 plots cumulative percentage of total variance data explained by principal components for
each currency zone. It can be seen that for EUR and USD the first 3. PCs are enough to explain at
least 99% of the total variability of term structure, which is in accordance with evidence in
literature. However, two more PCs are required in order to explain similar percentage of GBP and
JPY interest rate curves. This suggests that the daily changes in GBP and JPY term structures
exhibit a more complicated behaviour during the observation period.

16

Explanatory Power - EUR

Explanatory Power -USD

102.00 %
Cumulative % of Variance

Cumulative % of Variance

102.00 %
100.00 %
98.00 %
96.00 %
94.00 %
92.00 %
90.00 %
88.00 %

100.00 %
98.00 %
96.00 %
94.00 %
92.00 %
90.00 %
88.00 %

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Principal Component

Principal Component

Explanatory Power - GBP

Explanatory Power - JPY

Cumulative % of Variance

Cumulative % of Variance

102.00 %
100.00 %
98.00 %
96.00 %
94.00 %
92.00 %
90.00 %
88.00 %
86.00 %

102.00 %
100.00 %
98.00 %
96.00 %
94.00 %
92.00 %
90.00 %
88.00 %
86.00 %
84.00 %
82.00 %

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Principal Component

Principal Component

Figure 4. Cumulative percentage of total variance explained by the principal components

Breaking down the explanatory power of principal components on the variability of original
variables reveals further insight (figure 5). Considering the wish to explain at least 90% of the
variability of the interest rates across all maturities, we require 5 first PCs for each currency zone.
Therefore the model for each currency zone is:
xi i y = Bi1 y1 + Bi 2 y 2 + Bi 3 y 3 + Bi 4 y 4 + i 5 y 5
The 1st PC explains very little of money market interest rates, almost all of medium-term swap rates
and quite well very long swap rates. The 2nd PC shows opposite behavior: money market and longterm rates are more explained than medium-term rates by it. 3rd PC, similarly, is responsible for
explaining some of the variation in short and long-term ends of the interest rate curve. However, the
variation patterns differ from that of 2nd PC (otherwise the 3rd PC variation would be included in 2nd
PC). Interestingly, 4th and 5th PCs are significant in describing movements of short-term interest
rates - a result not often confronted in literature.

17

Breakdown of Explanatory Power - USD

4. PC
5. PC

Maturity

Y
25

5. PC

Maturity

Y
25

15

Total

8Y

1M

Y
25

15

Y
10

8Y

6Y

4Y

2Y

Total

4. PC

10

5. PC

3. PC

6Y

4. PC

2. PC

4Y

3. PC

1. PC

2Y

2. PC

Percentage

1. PC

6M

15

Breakdown of Explanatory Power - JPY

100,00 %
90,00 %
80,00 %
70,00 %
60,00 %
50,00 %
40,00 %
30,00 %
20,00 %
10,00 %
0,00 %
6M

100,00 %
90,00 %
80,00 %
70,00 %
60,00 %
50,00 %
40,00 %
30,00 %
20,00 %
10,00 %
0,00 %
1M

10

Maturity

Breakdown of Explanatory Power -GBP

Percentage

8Y

Total

1M

Y
25

15

10

8Y

6Y

4Y

2Y

6M

Total

3. PC

6Y

5. PC

2. PC

4Y

4. PC

1. PC

2Y

3. PC

100,00 %
90,00 %
80,00 %
70,00 %
60,00 %
50,00 %
40,00 %
30,00 %
20,00 %
10,00 %
0,00 %
6M

2. PC

Percentage

1. PC

1M

Percentage

Breakdown of Explanatory Power - EUR

100,00 %
90,00 %
80,00 %
70,00 %
60,00 %
50,00 %
40,00 %
30,00 %
20,00 %
10,00 %
0,00 %

Maturity

Figure 5. Breakdown of explanatory power of principal components

PC coefficients
Figure 6 shows to coefficients of the first five principal components for each currency zone. The
coefficients describe loadings of each principal component on a particular variable, i.e. the effect
of each PCs on different maturity. The distinction of loadings to curves in figure 4 is that loadings
only describe what effect each PC has on each maturity without considering the absolute magnitude
of the effect, whereas in figure 4 the curves represent the amount of total variation explained by
each component. In general the 1st PC shows quite flat behavior and therefore explains shift of the
interest rate curves. Similarly, the 2nd PCs for each currency zones show clear downward trends,
therefore explaining twist of the interest rate curves. The 3rd PCs shows a bell-shaped trend and
therefore explains the bow of the interest rate curves4. The 4th and 5th PCs are important for shortterm interest rates, but their rational interpretation is more difficult.

In literature the first three components are most often referred to as level, slope and curvature. This notation is
meaningful when performing PCA on levels, rather than differences. Unfortunately, however, the notation is employed
for differences quite often, too. This is an example of findings that PCA is a black box that is widely used but poorly
understood.

18

Loadings - EUR

Loadings - USD

3. PC
4. PC

-0,3

5. PC

-0,5
-0,7

5. PC

Maturity (months)

Loadings - GBP

Loadings - JPY
0,9
0,7

0,5
0,3
0,1

1. PC
2. PC
3. PC

-0,1
-0,3
-0,5

4. PC
5. PC

-0,7
-0,9

coefficient value

0,5

1. PC

0,3

2. PC

0,1

3. PC

-0,1

4. PC

-0,3

5. PC

-0,5
-0,7

Maturity (months)

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

7Y

8Y

5Y

6Y

4Y

2Y
3Y

12
M

3M

1M

30
Y

20
Y
25
Y

12
Y
15
Y

10
Y

8Y
9Y

6Y
7Y

4Y
5Y

2Y

3Y

3M
6M
12
M

-0,9
6M

coefficient value

4. PC

-0,5
-0,7
-0,9

Maturity (months)

0,9
0,7

1M

3. PC

1M
3M

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

7Y

8Y

6Y

5Y

4Y

3Y

2Y

6M
12
M

3M

1M

-0,9

2. PC

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

0,1
-0,1

1. PC

0,3
0,1
-0,1
-0,3

7Y
8Y

2. PC

5Y
6Y

1. PC

0,3

0,9
0,7
0,5

3Y
4Y

0,5

Coefficient value

coefficient value

0,7

6M
12
M
2Y

0,9

Maturity (months)

Figure 6. Loadings of first 3 principal components as features of interest rate curve: shift, twist and bow

Scenarios
Changes or shocks in PCs cause the interest rate structure to shift relative to the loadings of
particular PC in question. For example, if there is a twist shock, the effect will be larger on the
mid-term (2-5y) interest rates than short (-12m) or very long interest rates (+5y). Therefore one can
use loadings to construct several market shock scenarios and investigate how well the market
model composing of the chosen components captures these scenarios.
There are different methods for creating market scenarios. For example, one can assume that PCs
can move up or down some amount (for example 2.33 standard deviations corresponding to 1st and
99th percentiles of standard normal distribution). This method allows constructing 2n different
scenarios as possible combinations of chosen n PCs. I decided to create scenarios based on Monte
Carlo simulation. I create random vectors whose elements are drawn from multinormal distribution
with zero mean and covariance matrix equal to diagonal matrix of chosen eigenvalues (that
correspond to variances of chosen PCs) and multiply this vector with PCs to get different linear
combinations representing daily interest rate movement scenarios. The advantage of Monte Carlo
method is that one can choose the number of scenarios arbitrarily, the formation of scenarios (i.e.
the combinations of changes in chosen PCs) randomly and examine the correlations between
scenarios and original data, for example. Compared to simulating the original data, we now only
need to simulate 5 variables each time instead of 18, which clearly shows the advantage of PCA in
saving computational time.
19

Figure 7 plots the different scenarios for each currency zones. Thicker long-dashed curves
representing 5th and 95th quantiles are drawn on the same diagram together with a particular days
observed changes shown in short-dashed curves.
The scenarios seem to vary as expected within the quantiles. Only in few occasions are the quantiles
exceeded by a particular scenario (such as for JPY). This suggests that the market model with the
chosen PCs performs quite well in estimating the daily changes.

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

Scenarios - JPY

Basis Points

0
-2
-4
-6

0
-2
-4
-6

Maturity

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

7Y

8Y

5Y

6Y

4Y

3Y

2Y

M
12

1M

-12

30

Y
20

25

Y
12

15

Y
10

9Y

8Y

7Y

5Y

6Y

3Y

4Y

2Y

12

3M

6M

-10

3M

-8

-8

6M

Basis Points

7Y

Maturity

Scenarios - GBP

1M

8Y

5Y

Maturity

6Y

1M

9Y
10
Y
12
Y
15
Y
20
Y
25
Y
30
Y

8Y

6Y

7Y

5Y

3Y

4Y

2Y

12

3M

6M

1M

-8

3Y

-6

4Y

-4

0
-2

2Y

10
8
6
4
2
0
-2
-4
-6
-8
-10

12

4
Basis Points

Basis Points

3M

Scenarios - USD

6M

Scenarios - EUR
8

Maturity

Figure 7. Scenarios

Levels vs Differences
As noted before, taking first differences may artificially increase noise and therefore decrease
efficiency of PCA. To study this effect, I performed PCA on levels of interest rates, too. The results
suggest that 3 PCs is enough to explain most of the variation of all maturities (figure 8), compared
to 5 PCs required for differenced data. This supports the disadvantage of taking first difference.
Therefore one is faced with a trade-off between efficient estimation (low dimensionality of model)
and applicability of results (scenarios and other applications where standard deviation of PCs is
required). However, more extensive research, analysis and discussion on levels vs. differences are
beyond the scope of this study.

20

Breakdown of Explanatory Power - USD

1. PC

2. PC

3. PC

Total

Percentage

Percentage

Breakdown of Explanatory Power - EUR

100,0 %
90,0 %
80,0 %
70,0 %
60,0 %
50,0 %
40,0 %
30,0 %
20,0 %
10,0 %
0,0 %

100,0
90,0
80,0
70,0
60,0
50,0
40,0
30,0
20,0
10,0
0,0

%
%
%
%
%
%
%
%
%
%
%

Y Y Y Y Y Y
1M 3M 6M12M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10 12 15 20 25 30
Maturity

3. PC
Total

1. PC
2. PC
3. PC
Total

Percentage

Breakdown of Explanatory Power - JPY

100,0 %
90,0 %
80,0 %
70,0 %
60,0 %
50,0 %
40,0 %
30,0 %
20,0 %
10,0 %
0,0 %

1. PC

2. PC

3. PC

Total

1M
3M
6
12 M
M
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9
10Y
12Y
15Y
20Y
25Y
30Y
Y

1M
3M
6M
12
M
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9
10Y
12Y
15Y
20Y
25Y
30Y
Y

Percentage

2. PC

Y Y Y Y Y Y
1M 3M 6M12M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y10 12 15 20 25 30
Maturity

Breakdown of Explanatory Power - GBP

100,0 %
90,0 %
80,0 %
70,0 %
60,0 %
50,0 %
40,0 %
30,0 %
20,0 %
10,0 %
0,0 %

1. PC

Maturity

Maturity

Figure 8. Breakdown of explanatory power of principal components for levels of interest rates

4.5 Combined Currency Zone Results

Evidence presented in literature reveals that there may exist consistent, common influences across
the markets (Rodriques, 1997) offering opportunities to further reduce the dimension of market
models. I investigated correlations between PCs for different countries and perform PCA for
aggregate data.

Correlations
Research and analysis performed in literature proposes that some correlation between the first
components extracted from different country bond data exists although correlation between
second and third components is less evident (Rodrigues, 1997).
I investigated the correlations between first five principal components estimated for different
countries. Correlations are calculated from principal component scores for the observation period.
It can be seen that for 1. PC, all of the currency zones correlate quite strongly with each other,
highest being 0.79 for EUR/GBP and lowest being 0.53 for USD/JPY and GBP/JPY (table 1). This
means that the relative levels of interest rate changes have been quite stable between the currency
zones.
Only EUR/USD shows moderate correlation (0.33) for 2. PC, while other combinations correlate
much less obviously. This suggests that the twist effect (and therefore possibly monetary policy
21

actions) has been quite inconsistent between the currency zones during the observation period.
Similar small correlations are found for 3. PC. These findings support the evidence presented in
literature.
Interestingly, there is evidence of some EUR/USD, USD/GBP, USD/JPY and GBP/JPY correlation
for 4. PC. Similarly, 5. PC shows correlations of comparable magnitude. Taking into account
correlations for all PCs, it can be concluded that the interest rates fluctuate to some degree within
same dimensions. In other words, several variables can be found that explain movements of interest
rates across different currency zones, which suggests there exists some common global interest rate
movements.
1st Principal Component

2nd Principal Component

Correlation

EUR

USD

GBP

JPY

Correlation

EUR

USD

GBP

JPY

EUR

1,00

0,77

0,79

0,64

EUR

1,00

0,20

0,00

0,06

USD

0,77

1,00

0,65

0,53

USD

0,20

1,00

0,12

-0,17

GBP

0,79

0,65

1,00

0,53

GBP

0,00

0,12

1,00

-0,15

JPY

0,64

0,53

0,53

1,00

JPY

0,06

-0,17

-0,15

1,00

3rd Principal Component

4th Principal Component

Correlation

EUR

USD

GBP

JPY

Correlation

EUR

USD

GBP

JPY

EUR

1,00

0,33

-0,12

0,02

EUR

1,00

-0,10

0,04

0,05

USD

0,33

1,00

-0,17

-0,18

USD

-0,10

1,00

-0,11

-0,08

GBP

-0,12

-0,17

1,00

0,12

GBP

0,04

-0,11

1,00

0,00

JPY

0,02

-0,18

0,12

1,00

JPY

0,05

-0,08

0,00

1,00

5th Principal Component

Correlation

EUR

USD

GBP

JPY

EUR

1,00

0,17

0,14

0,00

USD

0,17

1,00

-0,05

-0,16

GBP

0,14

-0,05

1,00

-0,19

JPY

0,00

-0,16

-0,19

1,00

Table 1. Correlations of principal components between currency zones

However, it should be noted that the results are dependent on the observation period. Empirical
evidence has shown that correlations across different currency zones may change significantly over
a few-year observation period (Rodrigues, 1997). This suggests that multiple currency zone models
are less stable than single country models.

PCA on Combined Data

Performing PCA on data that includes all individual currency zones data combined reveals slightly
different pictures of global interest rate structures.
1. PC explains about 67% of the total variability of data that includes daily changes of interest rates
for all four currency zones (figure 9). This figure rises to 86% with 3 PCs but 14 PCs is required to
22

capture 99% of the total variability. In other words, quadrupling the dimensions about quadruples
the number of PCs needed to explain the variability of the data. This suggests that there is not much
scope for additional dimension reduction by combining different interest rate markets.

Cumulative % of Variance

Explanatory Power - Currency Zones Combined

120,00 %
100,00 %
80,00 %
60,00 %
40,00 %
20,00 %
0,00 %
1 5

9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69
Principal Components

Figure 9. Cumulative percentage of total variance explained by the principal components

Breaking down the explanatory power of PCs reveals that PCA on aggregate data seems most
efficiently work to long-term interest rates, while short-term interest rates show less common
behavior across currency zones. For example, while first common 5 PCs explain 99% of JPY 4 year
swap variability, the figure is less than 30% for 6 month Libor for the same currency zone (table 2).
However, the differences across currency zones are so large that further general conclusions are
hard to be extracted.
Currency
Zone
First 3
PCs

First 5
PCs

EUR
First 10
PCs

First 20
PCs

First 3
PCs

First 5
PCs

USD
First 10
PCs

First 20
PCs

1M

3,4 %

8,0 %

23,0 %

94,5 %

5,9 %

27,5 %

37,6 %

95,8 %

3M

0,3 %

1,4 %

62,5 %

88,6 %

2,8 %

73,8 %

87,1 %

97,5 %

6M

6,7 %

12,4 %

83,1 %

97,7 %

6,5 %

83,8 %

97,8 %

99,2 %

12M

16,4 %

22,1 %

90,3 %

99,1 %

9,5 %

84,4 %

98,2 %

99,7 %

2Y

74,4 %

84,0 %

98,3 %

99,5 %

85,7 %

90,6 %

98,9 %

99,8 %

3Y

78,7 %

89,6 %

98,6 %

99,6 %

90,4 %

94,0 %

99,3 %

99,8 %

4Y

83,8 %

94,5 %

99,4 %

99,9 %

94,1 %

96,8 %

99,5 %

99,7 %

5Y

85,4 %

96,6 %

99,4 %

99,8 %

96,6 %

98,3 %

99,8 %

99,9 %

6Y

87,4 %

98,4 %

99,5 %

99,9 %

97,8 %

99,0 %

99,7 %

99,8 %

7Y

88,1 %

99,4 %

99,6 %

99,8 %

99,0 %

99,8 %

99,9 %

99,9 %

8Y

87,9 %

99,7 %

99,7 %

99,9 %

99,2 %

99,8 %

99,8 %

99,9 %

9Y

87,8 %

99,4 %

99,6 %

99,8 %

99,3 %

99,8 %

99,8 %

99,9 %

10Y

87,3 %

99,1 %

99,6 %

99,9 %

99,0 %

99,5 %

99,7 %

99,8 %

12Y

86,5 %

98,4 %

99,7 %

99,9 %

98,5 %

99,2 %

99,8 %

99,9 %

15Y

83,9 %

97,0 %

99,7 %

99,9 %

97,5 %

98,4 %

99,8 %

99,9 %

20Y

80,8 %

94,7 %

99,2 %

99,8 %

95,8 %

97,2 %

99,8 %

99,9 %

25Y

80,2 %

93,9 %

98,9 %

99,8 %

95,0 %

96,6 %

99,7 %

99,9 %

30Y

78,4 %

92,5 %

98,8 %

99,8 %

93,7 %

95,6 %

99,5 %

99,8 %

Maturity

23

Currency
Zone
First 3
PCs

First 5
PCs

GBP
First 10
PCs

First 20
PCs

First 3
PCs

First 5
PCs

First 10
PCs

First 20
PCs

1M

7,3 %

14,3 %

26,1 %

38,7 %

20,2 %

22,5 %

49,1 %

67,8 %

3M

18,1 %

26,2 %

50,4 %

68,3 %

13,0 %

19,6 %

59,7 %

95,4 %

6M

20,5 %

42,1 %

76,3 %

96,2 %

19,2 %

28,0 %

68,1 %

97,2 %

12M

27,5 %

52,5 %

85,7 %

99,3 %

19,4 %

27,4 %

62,7 %

98,3 %

2Y

76,7 %

78,9 %

96,0 %

99,4 %

70,3 %

74,4 %

95,3 %

99,5 %

3Y

81,2 %

82,3 %

96,5 %

99,6 %

80,7 %

84,3 %

97,7 %

99,6 %

4Y

90,0 %

91,2 %

98,9 %

99,6 %

89,4 %

93,5 %

99,0 %

99,4 %

5Y

93,2 %

94,5 %

98,8 %

99,5 %

93,7 %

95,9 %

99,1 %

99,6 %

6Y

94,9 %

96,9 %

98,7 %

99,6 %

94,7 %

96,8 %

99,3 %

99,7 %

7Y

96,2 %

98,6 %

99,2 %

99,7 %

95,8 %

97,6 %

99,3 %

99,9 %

8Y

95,7 %

98,9 %

99,1 %

99,6 %

96,5 %

97,9 %

99,3 %

99,9 %

Maturity

JPY

9Y

94,9 %

98,8 %

99,0 %

99,7 %

96,8 %

97,9 %

99,1 %

99,7 %

10Y

94,9 %

98,8 %

99,0 %

99,5 %

96,3 %

97,1 %

98,8 %

99,5 %

12Y

95,1 %

98,1 %

98,8 %

99,1 %

88,8 %

91,2 %

97,5 %

98,4 %

15Y

90,1 %

95,5 %

97,4 %

99,6 %

86,4 %

88,3 %

96,4 %

99,6 %

20Y

89,1 %

94,6 %

98,1 %

98,8 %

81,7 %

85,5 %

98,0 %

99,5 %

25Y

79,7 %

83,7 %

90,7 %

99,9 %

78,2 %

82,7 %

98,8 %

99,7 %

30Y

80,0 %

89,0 %

95,3 %

99,6 %

74,9 %

80,0 %

98,2 %

99,7 %

Table 2. Cumulative explanatory power of principal components calculated from data consisting of all currency
zones interest rate curves.

5. Conclusions and Discussion

This study has shown that PCA offers the opportunity to significantly reduce data dimensions of
term structure of interest rates while retaining most of the information held by the data. In addition,
the results of PCA form a basis for further applications and analysis, such as effective Monte Carlo
Simulation regarding the measurement of market risk deriving from interest rate movements.
The study has revealed that although there are clear correlations between currency zones results,
combining the data does not allow further considerable reduction in dimensions. However, the
existence of correlations allows one to think of other ways of depicting global movements with
fewer variables.
An interesting result of PCA performed in this study is that five PCs are required to explain at least
90% of the movements of interest rate curves whereas, for the same original data set, three PCs are
enough to explain the levels of interest rates to similar degree of accuracy. This finding may form a
basis for further investigation given that both methods have advantages and disadvantages.

24

References
[1]

Alexander, C., Key Market Risk Factors: Identification and Applications, The Q-Group
Seminar on Risk, April 2000

[2]

Clustan Ltd website, http://www.clustan.com/pca.html, accessed 14.8.2006

[3]

Cont, R., da Fonseca J., Dynamics of Implied Volatility Surfaces, Research Paper,
Quantitative Finance, Volume 2, No. 1, 2002, pages 45-60, http://www.instituteuroplace.com/files/pdf/doc977971.pdf, accessed 14.8.2006

[4]

Fengler, M., Hrdle, W. Villa, C., The Dynamics of Implied Volatilities: A Common
Principal Components Approach, Discussion paper No. 38/2001, Humboldt University,
Germany, 2001

[5]

Frye, J., Principals of Risk: Finding Value-at-Risk Through Factor-Based Interest Rate
Scenarios, NationsBanc-CRT, April 1997

[6]

Heidari, M. & Wu, L., Are Interest Rate Derivatives Spanned by the Term Structure of
Interest Rates?, The Journal of Fixed Income, Volume 13, No. 1, June 2003, pages 75-86.

[7]

Hull, J., Options, Futures, And Other Derivatives, Sixth Edition, Prentice Hall Finance
Series, Upper Saddle River, NJ, 2005

[8]

Jorion, P., Value at Risk: The New Benchmark for Managing Financial Risk, Second
Edition, McGraw-Hill International Edition, Singapore, 2002

[9]

Litterman, R., Scheinkman, J., Common Factors Affecting Bond Returns, The Journal of
Fixed Income 1, June 1991, pages 54-61

[10]

Lpez, D., Value at Risk for the Term Structure of Interest Rates: An Orthogonal Approach,
The ICFAI Journal of Financial Economics, Volume 3, Issue 4, December 2005, pages 4976

[11]

Loretan, M., Generating market risk scenarios using principal components analysis:
methodological and practical considerations, Individual Research Paper, Federal Reserve
Board, March 1997, http://www.bis.org/publ/ecsc07c.pdf, accessed 14.8.2006

[12]

Kreinin, A., Merkoulovitch, L., Rosen, D., Zerbs, M., Principal Component Analysis in
Quasi Monte Carlo Simulation, Algo Research Quarterly, Volume 1, No. 2, December
1998, pages 21-30, http://www.gloriamundi.org/picsresources/aklmdrmz2.pdf, accessed
14.8.2006

25

[13]

Mellin, I. Pkomponenttianalyysi, Helsinki University Technology, Systems Analysis

Laboratory, course material, 2004,
http://www.sal.tkk.fi/Opinnot/Mat-2.112/pdf/PCOMP10.pdf, accessed 14.8.2006

[14]

Rodrigues, A., P., Term Structure and volatility shocks, Federal Reserve Bank of New York,
June
1997,
http://www.bis.org/publ/ecsc07d.pdf?bcsi_scan_9C13D4DDCDD1672E=0&bcsi_scan_filen
ame=ecsc07d.pdf, accessed 14.8.2006

[15]

Shlens, J., A Tutorial on Principal Component Analysis: Derivation, Discussion and

Singular Value Decomposition, Systems Neurobiology Laboratory, Salk Institute, March
http://neurobot.bio.auth.gr/Tutorials/Documents/pca_paper_tut_2.pdf,
accessed
2003,
14.8.2006

[16]

Wu, T., What Makes the Yield Curve Move, FRBSF Economic Letter, Number 2003-15,
June 6, 2003

26