Principal Components Analysis (PCA)

FINANCIAL PRICING MIDTERM

PRESENTATION
INSTRUCTOR: PROFESSOR ANN SHAWING YANG

SANDER MÄGI RA6977448

TUAN ANH RA6967566

2009/6/25
 Contents
2

y Introduction to PCA
y Problems and limitations
y Article 1
y Article 2
y Article 3
y Article 4
y Article 5

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 Why?
3

y You have lots of data…

y …but, it’s all very confusing…
y …there are too many variables to consider…
y …some of them are probably insignificant…
y …WHAT TO DO?

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 PCA
4

y Use Principal
Components
Analysis (PCA)!!!

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 Introduction to PCA (1)
5

y PCA was invented in 1901 by Karl Pearson

y A tool for (multivariate) data analysis used in many
fields
y Generally used in analyzing patterns:
{ Changes in stock market
{ Changes in commodity markets
{ Economic growth
{ Facial recognition
{ Neuroscience
{ Etc.

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 Introduction to PCA (2)
6

y Basic assumptions:
{ I. Linearity

{ II. Large variances have important structure

{ III. The principal components are orthogonal = perpendicular

y How to calculate:
{ 1. Organize data as an m×n matrix, where m is the number of
measurement types and n is the number of samples
{ 2. Subtract off the mean for each measurement type

{ 3. Calculate covariance matrix

{ 4. Calculate the eigenvectors and eigenvalues of the covariance

matrix

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 Introduction to PCA (3)
7

y Example:

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 Introduction to PCA(4)
8

y Philippatos, Christofi, & Christofi (1983) explain:

y PCA is a special case of Factor Analysis that is highly useful
in the analysis of many time series and the search for
patterns of movement common to several series (true factor
analysis makes different assumptions about the underlying
structure and solves eigenvectors of a slightly different
matrix)
y Clearly, this approach is superior to many of the bivariate
statistical techniques used earlier, in that it explores the
interrelationships among a set of variables caused by
common "factors," mostly economic in nature

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 Introduction to PCA(5)
9

y PCA is a simple, non-parametric method for extracting

relevant information from confusing data sets
y PCA is a way of identifying patterns in data, and expressing
the data in such a way as to highlight their similarities and
differences
y A primary benefit of PCA arises from quantifying the
importance of each dimension for describing the variability
of a data set
y PCA can also be used to compress the data, ie. by reducing
the number of dimensions, without much loss of
information

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 Introduction to PCA (6)
10

VARIATION EXPLAINED BY EACH  SUM OF EIGENVALUE
PRINCIPAL COMPONENT 
=
NUMBER OF VARIABLES

y Principal component - a linear combination of the original

variables
y Eigenvectors - the coefficients of the original variables used to
construct factors
y Eigenvalue - a corresponding scalar value for each eigenvector
of a linear transformation

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 Limitations of PCA (1)
11

y Mainly because of main assumptions

y 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.
y 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.

Malava (2006)
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 Limitations of PCA (2)
12

y In addition, for PCA to work exactly, one should use

standardized data so that the mean is zero.
y 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.

Malava (2006)
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Article Review
13

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 Changes in the risk structure of stock returns: Consumer
Confidence and the dotcom bubble (2007)
Lawrence Leger , Vitor Leone
14

y Views economic variables that help explain principal

components in UK stock returns
y Three data periods (01/1985 to 12/1990, 01/1991 to
12/1996, 01/1997 to 12/2001)
y Complicated analysis (description) using PCA
y Dotcom bubble also effects

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 Changes in the risk structure of stock returns: Consumer
Confidence andArticle
the dotcom1 bubble (2007)
Lawrence Leger , Vitor Leone
15

y The loading pattern on explanatory variables for the

first component in a ‘bubble’ period is distinctive and
consistent with a bubble/crash market.
y The second component shows a loading pattern on a
Consumer Confidence variable in a pre-bubble
period only.
y Observe apparently systematic changes in the
structure of risk, and conjecture that Consumer
Confidence captures a change in market sentiment
that could be a signal for the evolution of stock
prices.
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 Co-movements of sector index returns in the world‘s major
stock markets in bull and bear markets: Portfolio
diversification implications (2006)
Ilhan Meric , Mitchell16Ratner , Gulser Meric

y Views co-movements of different sector indexes in stock

markets in 5 countries: USA, UK, Germany, France,
Japan
y 2 time periods: Bull market and Bear market
y Use PCA and Granger causality

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 Co-movements of sector index returns in the world‘s major
Article
stock markets in bull 2 markets: Portfolio
and bear
diversification implications (2006)
Ilhan Meric , Mitchell17Ratner , Gulser Meric
y The returns of the ten sector indexes and the national benchmark
stock market index of each country are used as inputs in the
principal components analysis (PCA) program to group the
indexes in terms of the similarities of their movements.
y In the bear market, there are two statistically significant
principal components in each of the five countries. The sectors
with high factor loadings in the same principal component are
highly correlated and those with high factor loadings in different
principal components have a low correlation. Therefore, in the
bear market, for successful domestic sector portfolio
diversification in each country, investors should pick one sector
with a high factor loading from each of the two principal
components.

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 Co-movements of sector index returns in the world‘s major
Article
stock markets in bull 2 markets: Portfolio
and bear
diversification implications (2006)
Ilhan Meric , Mitchell18Ratner , Gulser Meric

y Find that, in a bull market, investors can obtain

more benefit with global diversification than with
domestic diversification even if they invest in the
same sector in different countries as opposed to
investing in different sectors within the same
country.
y In a bear market,the sectors of different countries
tend to be more closely correlated and country
diversification opportunities are limited

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 Detection of financial distress via multivariate statistical analysis
S.Ganesalingam
Journal of Managerial Finance
19

y Introduction:
9 In this paper we have focused our attention to predict financial
distress among a selection of major Australian companies.
Seventy-one such firms were subjected to the analysis to
determine the various facts about the companies, in particular its
long-term stability.

9 Furthermore such analysis will help an investor to hedge a

portfolio so as to choose different companies from different
clusters to maximize their portfolio’s diversity and resilience to
changes in the market.

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Detection of financial distress via multivariate statistical analysis
S.Ganesalingam
Journal of Managerial Finance

y Aim, choice of variables and data:

9 From a standard source of Australian stock data for the period
1986 to 1991
9 The data includes a combination of 42 successful companies
and 29 failed companies in the period considered.

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 Detection of financial distress via multivariate statistical analysis
S.Ganesalingam
Journal of Managerial Finance

y Statistical techniques employed in this study:

9 Principal components analysis:
PCA provides a reduction of the data without loss of much information
we are seeking from the data
9 Factor analysis:
Similar to the PC analysis, the factor analysis also possess this dual
quality and the aim is to summarize the inter-relationships among the
variables in a concise but accurate manner as an aid in conceptualisation.
9 Discriminant analysis:
Discriminant analysis as a whole is concerned with the
relationship between a categorical variable and a set of inter-
related variables.
9 Cluster analysis:
The techniques of cluster analysis are useful tools for data
analysis in several different situations.
21 2009/6/25
 Detection of financial distress via multivariate statistical analysis
S.Ganesalingam
Journal of Managerial Finance

22

y Conclusions:
9 These methods make it possible to ask specific and precise
questions of considerable complexity in natural settings.
This makes it possible to conduct theoretically significant
research and to evaluate the effects of naturally occurring,
parametric variations in the context in which they normally
occur.

9 Using these techniques we have identified some operational

indexes and some sensible grouping of the companies that
could be used as operational representatives for future
decision-making process.

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 Co-movement of the U.S, U.K, and Middle East stock markets
Gulser Meric, Mitchell Ratner, Ilhan Meric
Journal of Middle Eastern Finance and Economics
23

y Introduction:

9 In this paper, they study the co-movement of the weekly

index returns of the Egyptian, Israeli, Jordanian,
Turkish, U.K, and U.S stock markets.

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 Co-movement of the U.S, U.K, and Middle East stock markets
Gulser Meric, Mitchell Ratner, Ilhan Meric
Journal of Middle Eastern Finance and Economics
24

y Data and Methodology:

9 Using the Morgan Stanley Capital International (MSCI)
weekly U.S dollar stock market indexes.
9 For the September 9,1996 – September 11,2006 period.
9 Using correlation analysis to study the co-movement of
the six stock markets.
9 Using the PCA technique to study the co-movement of
the correlations between the markets.

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 Co-movement of the U.S, U.K, and Middle East stock markets
Gulser Meric, Mitchell Ratner, Ilhan Meric
Journal of Middle Eastern Finance and Economics
25

y Results:
9 Turkish stock market has the highest average weekly return and
the highest volatility. The Egyptian and Jordanian have highest
weekly return per unit of volatility risk, the Israeli and U.K
stock markets have the lowest weekly return per unit of
volatility risk.

9 The correlation analysis results reveal that there is very low

correlation between the Egyptian, Israeli, Jordanian, and
Turkish stock markets.

9 The average correlation statistics indicate that the Jordanian

stock market is the best prospect in the region for portfolio
diversification
2009/6/25
 Co-movement of the U.S, U.K, and Middle East stock markets
Gulser Meric, Mitchell Ratner, Ilhan Meric
Journal of Middle Eastern Finance and Economics
26

y Results:
9 The most volatile correlation is between the Turkish and U.S
stock markets and between Egyptian and Turkish. The least
volatile correlation is between Egyptian and U.S, between
Egyptian and Israeli, and between the Israeli and Jordanian stock
markets.

9 Some correlation between the six stock markets are positively

correlated (they tend to move the same direction), some are
negatively correlated (they tend to move the opposite direction).
The U.S stock markets correlations with the Egyptian and
Turkish are highly positively correlated (0.43). The Jordanian
stock market correlations with the Egyptian and Turkish are
highly negatively correlated (-0.53).

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 Principal components analysis for correlated curves and seasonal
commodities: The case of the petroleum market
Carlos Tolmasky, Dmitry Hindanov; The journal of Futures markets
27

¾ This article presents a family of term structure models that can be

applied to value contingent claims in multicommodity and
seasonal markets.

¾ We show how to deal with the problem of having to value

products depending on the “whole” market, such as spread
options on contracts on a single commodity maturing at different
times (time spreads) or spread options on the added value of the
products derived from the raw commodity (crack spreads).

¾ we show how to build term structure models for a commodity

that experiences seasonality, such as heating oil.

2009/6/25
 Principal components analysis for correlated curves and seasonal
commodities: The case of the petroleum market
Carlos Tolmasky, Dmitry Hindanov; The journal of Futures markets
28

¾ To find the volatility functions we will analyze the principal

components of the correlation matrix of the historical returns.

¾ This methodology will ultimately allow us to capture the variance

of the multiple-curve market with the minimum number of
factors (which will lead to a less computationally intensive
model).

¾ We used principal components analysis to find the orthogonal

factors and corresponding importances.

2009/6/25
 Principal components analysis for correlated curves and seasonal
commodities: The case of the petroleum market
Carlos Tolmasky, Dmitry Hindanov; The journal of Futures markets
29

y CONCLUSIONS
9 In this article we have extended the analysis done by Cortazar
and Schwartz (1994) to the petroleum market. In doing so, we
have shown how to use all the information present in the current
two-curve term structure of futures prices. we found that four
factors are enough to explain 99% of the variance present in the
multiple curve market.

9 We have also studied how to extend the analysis to seasonal

commodities. We have found that, in the case of heating oil, the
most important factors are still level, steepness, and curvature,
but their importances follow a seasonal pattern.

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Thanks for your attention！

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