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# Statistical Methods in Finance Final Project

## Andrs Jaime (aaj2132) Julio Ruiz (jcr2165) Ezequiel Zambaglione (eaz2109)

1. Introduction Since the financial crisis began, financial markets have gone through many structural changes, which have transformed the dynamics of several asset classes. Moreover, interventions from policy makers into the markets have added more distortions on liquidity and how market reacts to macroeconomic variables and news. In this study, we try to understand how things have changed during the last few years in the treasury yield curve in the United States. To do this, we decided to use Principal Component Analysis (PCA) as a tool, calculating daily Principal Components (PC) using a sample data of one year for each PC. After that, we proceed to analyze how PCA changes over time and to link those changes with market events. Our data consist of the following yields: 3-month, 6-month, 2-years, 3-years, 5-years, 10years and 30-years1. Finally, we present one application of the PCA and its consequences given the structural changes in the US Term Structure Yield Curve and the conclusions. 2. Principal Component Analysis Theory Assume ( ) of d-dimensional random vectors with mean vector and covariance matrix . One goal of PCA is finding structure in . Suppose that where are i.i.d. mean zero random variables and o is some fixed vector, which can be taken to have norm 1. This says that all the variation among the mean-centered * + vector in the one dimensional space spanned by o. The covariance matrix of is . The vector o is called the first principal axis of and is the only eigenvector of with a nonzero eigenvalue, so o can be ( ) estimated by an eigen-decomposition of the estimated covariance matrix. where O is an orthogonal matrix whose columns are the eigenvectors of and are the corresponding eigenvalues. A normed linear combination of is of the form where the norm of alpha is equal to 1. (sum of squared

alphas equals one). The first principal component is the normed linear combination with the greatest variance. The variation ( ) in the direction , where is any fixed vector with norm 1 is . The first PC maximizes the last equation. The maximizer is , the eigenvector corresponding to the largest eigenvalue, and is called the first principal axis. The projection, for , onto this vector are called the first principal component. After the first principal component has been found, one searches for the direction of maximum variation perpendicular to the first principal axis (eigenvector).This mean maximizing again the same equation subject to and . The maximizer is the second principal axis , and the second principal component is the set of projections for , onto this axis. We continue doing the same until we find all the PCs. The set of projections mentioned before are the i-th principal component and the variance of the i-th principal component is . By using this, we can calculate the proportion of variance due to a particular PC i.e. ( proportion of variance of more than one PC. In our case study, we can use the sample covariance or correlation matrix to calculate the PCs. Also, instead of using the yields in each node, we decided to use the net change in the yields, so the series is stationary. In the case of a yield curve, long term bonds tend to be more volatile than short term bond. This is important because if changes are larger in long-dated bonds, it is necessary to use the correlation matrix instead of the covariance matrix, fixing the issue of not using variables in the same unit. Another solution could be using percentage changes in the yields alongside with the covariance matrix. We ran PCA using data from January 2010 to April 2012
1

## ), and also the

We decided to get rid of the 1-year and 20-year series because of the lack of information for some relevant periods.

As we can see in figure 1.1 and 1.2, the first three principal components explains 93% of the variance, leaving only 7% of explanatory value to the other four PC. Figure 1.1
Proportion of variance
65.91%
86.55% 65.91% 93.00% 100.00% 96.45% 98.89% 99.70%

Figure 1.2
Cummulative proportion of variance

20.64% 6.45%

## 3.45% 2.44% 0.81% 0.30% 4 5 6 7

Principal Component

Principal Component

## 2 1.20 21% 87%

3 0.67 6% 93%

4 0.49 3% 96%

5 0.41 2% 99%

6 0.24 1% 100%

7 0.15 0% 100%

Furthermore, the first 3 PCs show an intuitive interpretation, which makes them our focus on this project. The eigenvector of the first PC contains only positive values (figure 1.3), and it could be thought as parallel shifts in the curve, as it is correlated positively with all the bond maturities. This PC alone explains 66% of the variation in the yields. Figure 1.3 Eigenvector-1
0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 3-months 6-months 2-years 3-years 5-years 10-years 30-years
0.40 0.20 0.00 -0.20 -0.40 3-months 6-months 2-years 3-years 5-years 10-years 30-years 0.80 0.60 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40 -0.60 -0.80 3-months 6-months 2-years 3-years 5-years 10-years 30-years

## Figure 1.5 Eigenvector-3

In turn, the second principal component explains by itself almost 21% of the variation in yields (figure 1.4). In this case, the principal component can be interpreted as the one that accounts for the changes in the slope of the yield curve. This PC is positively correlated with the changes in yields in the short end of the curve (up to two years), while shows negative correlation with longer maturities (3 to 30 years). Finally, the third principal component explains alone 6.45% percent of the change in yields. In figure 1.5 we can see that 3month, 10-years and 30-years shows positive correlation; 6-months and 5-years shows practically no correlation while the remaining nodes of the curve shows negative correlation. We can interpret this PC as the one which explains the variation in the shape of the yield curve.

3. Results of Statistical Analysis Our principal results are summarized in figure 2.1; the cumulative proportions (CP) of the three most important principal components were plotted against time from December 22, 2000 to April 5, 2012. The figure shows that the CP eigenvalue1, the component that explains the most, has been relatively stable from 2002 through the first half of 2007. The same applies for the CP of eigenvalue2 and eigenvalue3. However, beginning in the second half of 2007, the CPs started to change. For instance, the CP of eigenvalue1 went from a band approximately within 70%-80% to 70%-60%. The CP of eigenvalue2 reflects the same trend, whereas the CP of eigenvalue3 appears to remain fairly constant, reflecting that the eigenvalue3 gained participation in the total CP. In addition, figure 2.2 reflects more clearly the fact that the eigenvalue3 gained participation, while eigenvalue1 and eigenvalue2 reduced its participation. Figure 2.2 plots the level of three most important eigenvalues against time, showing that between September 2007 and October 2008 the level of eigenvalue3 increased while the levels of eigenvalue1 and eigenvalue2 decreased. Figure 2.1 and 2.2 clearly shows a structural changes in the variability of the principal components, defined as the interest rates movements due to the three main principal components related to the level, steepness and curvature of the yield curve. This means that not for all period parallel shifts, changes in the slope and changes in the shape of the yield curve (curvature) have the same influence in the volatility of the yield structure. Figure 2.2 Eigenvalues
6 5.5
120

Figure 2.1 Eigenvalues Cumulative Proportion and S&P 500 Volatility Index (VIX)
100

Eigenval3

5 4.5 4

90

100

Eigenval1
1.9

Eigenval2
80 80

3.5 3 1.5 1.3 1.1 0.9 0.7 0.5 0.3 0.1 -0.1

Eigenval2

70

60

Eigenval1
60 40

50 20

Eigenval3

## 0.9 0.7 0.5

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We have shown that the CP of eigenvalues in this case are not constant through time. However, the question about which factors might have induced such changes in the variability of the principal components remains. The period in which the variability of the principal components suffered a mayor change coincides with the financial crisis. Since during this period the market experienced high volatility and several interventions from the Federal Reserve System we will explore indicators that reflects those conditions. First, in order to see if market volatility affected the behavior of eigenvalues through time, we plotted the S&P 500 Volatility Index (VIX) in figure 2.1. The VIX reflects the volatility in the equity market, so whenever investor perceive high volatility in the equity market they will fight back to quality buying a safe asset, in particular US bonds. This in turn will affect the fixed income market, affecting the yields. The period of highest volatility experienced by the VIX is shortly after the Lehman brother collapse, this period of high volatility matches the period where the biggest change in in the CP of eigenvalue1 and eigenvalue2 occurred. The overlap of periods suggests that volatility may have caused the structure to change.

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Figure 2.4 Stocks of Treasuries Securities in FED reserves Figure 2.3 Federal Fund Target Rate
0.06 0.05 0.04 0.03 0.02 0.01 0

Billions of Dollars
1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Dec-2002 Jul-2004 Jan-2006 Aug-2007 Mar-2009 Sep-2010 Apr-2012
Lehman Brothers sub-prime crisis QEII

Mar-03

Oct-03

Jul-05

Feb-06

Sep-06

Apr-07

Nov-07

Jun-08

Jan-09

Aug-09

Mar-10

Oct-10

May-11

May-04

Aug-02

Regarding the interventions of the Federal Reserve (FED) System, figure 2.3 and 2.4 display two indicators that reflect FEDs monetary policy. The first one shows the Federal Funds Target Rate (FFR) and the second figure shows the stock of Treasuries securities in the FED reserves. After the sub-prime mortgage crisis the FED began to implement an accommodative monetary policy to offset the negative effects of the crisis in the real sector of the economy. In addition, the FED sold treasuries bonds to provide liquidity in the bond market in moments of uncertainty (figure 2.3). Afterwards, the FFR reached the floor of 0-.25%, impeding the FED to implement a further boost to the economy via the FFR, so the FED decided to implement Quantitative Easing I (QEI) and two (QEII), buying securities in the market and injecting cash into the economy. In particular QEII was based on buying longterm treasuries securities, figure 2.4 reflects the increase of treasuries securities in the FEDs balance sheets. As in the VIX, these policies could have affected the behavior of the PC eigenvalues. After finding the possible causes of these changes, we turn our attention to the implication of these fluctuations. In other words, we explored if these variations affected also the correlation of the different maturities in the eigenvector. Figures 2.5, 2.6 and 2.7 show eigen-vector1, eigen-vector2 and eigen-vector3 respectively for three different dates. We choose these dates to reflect a pre-period crisis, right after the collapse of Lehman brothers and a relatively more stable period after the Lehman brothers collapse.

0.5 0.4

Dec-04

1

Dec-11

Jan-02

1

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0.8

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-0.4

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-0.6

-0.6

## -0.1 1-month 6-months 2-years 3-years 5-years 10-years 30-years

-0.8 1-month 6-months 2-years 3-years 5-years 10-years 30-years

1/11/11
-0.8 1-month 6-months 2-years 3-years 5-years 10-years 30-years

The three figures exhibit a different behavior of the Eigen-vectors during the crisis period. The eigenvector1 dont show a parallel shift anymore, as the 3-year maturity presents a negative correlation. In the case of the eigenvector2, which explains changes in the slope of the yield curve, the maturities that in more stable periods were positives in

more volatile periods became negative. Likewise, eigenvector3 displayed a different behavior in periods of different volatility. One possible explanation is related to a disorderly purchase of treasury securities because of the high uncertainty, the so called fly to quality. In this event, investors usually buy short-term securities, but because of the extraordinary high volatility and illiquidity in the markets, investors start choosing whatever is available. Also, the episode of interventions help to explain why the principal component three explains more than it used to do in the early 2000. 4. An application of Principal Components Analysis One application of the PCA is for immunization of bond portfolios. The Principal Components allow us to isolate the exposure to the most important determinants of risk, i.e. parallel changes, changes in the slope of the curve and changes in its curvature. In the following section we give an example of how perform this operation and also show the effects of the changes in the PC analyzed in the previous sections 2. First of all, it is necessary to run a linear regression between the zero coupon bonds of different maturities against each of the PC. As it was showed in the first section, on average the first PC explain almost the 93% of the variability of the interest rates, so you can obtain a model that explains the changes in bonds prices by changes in the first three PC. The regressions are given by the following expressions, ( ( ) )

where Pji represents the time series of the zero coupon bonds P j (j=3m, 6m,,30yrs), PCmi=rji*EVm with EVm the eigenvector corresponding to the eigenvalue m and and i are the parameters to estimate. Once you have these j models to explain the variability of the zero coupon bonds of different maturities, it is possible to perform the same operation on the portfolio that is going to be immunize, so it is possible to know how much the portfolio is exposed to changes in the first three principal components.

Where Ri is the time series of the changes in the portfolio and i are the parameters to estimate Finally, to perform the immunization of the portfolio it is necessary to add as many bonds as PC is desired to hedge, this means add xi*Pj to it, in order to make Ri=0, where xi are the amount of bond Pj necessary to perform the immunization. For example, you can choose the three-month, 2 years and 10 years zero coupon bonds and solve the following system of equations,

The idea of the portfolio immunization using PC is make it neutral to movements in the term structure of interest rates, or at least more than 90% of its variation, with only three assets instead of using the whole curve.

To estimate the principal components of each year we used variance-covariance matrix of the previous year.

However, as it was presented in the previous sections, after the financial crisis of 2007 and with the intervention of the Federal Reserve in the US Treasury market, in the last years the principal components showed a different behavior than they used to have in the previous years. The following graphs show a comparison between the actual changes in the interest rates and the ones estimated with the first three PC for the three and six months rates and ten an thirty years rates during the year 2006, 2008 and 2011. These graphs show that the estimation of the variability in these rates for the year 2006 using the first three PC is almost perfect, as well as it would be the immunization of the portfolio.
Figure 2.7 - Difference between actual rates and PC estimates
2006
0,60% 1,00% 3 months 10 years 6 months 30 years

2008
0,60% 3 months

2011
6 months 1,00%

0,40% 0,20%
0,00% -0,20% -0,40% -0,60% -0,80% -1,00%

0,80%
Principal Axis

0,40% 0,20%
0,00% -0,20% -0,40% Secondary axis -0,60% -0,80% -1,00%

10 years

30 years

0,80% 0,60%
0,40% 0,20% 0,00% -0,20%

0,60%
0,40% Principal Axis 0,20% 0,00% -0,20% Secondary axis -0,40% -0,60%

Principal Axis

Secondary axis

-0,40% -0,60%

However, when we perform the same analysis to the following years it is possible to see that, accordingly to the previous sections, the estimation is not as good as before, leading to important errors in the immunization. This characteristic is present in 2008, as you can see in the graph, and in all the following years. It is important to remark that the year 2011 shows some particularity. Despite the PC estimation for the short rates seem to stabilize its behavior, it is not the case for the long rates. This particular behavior could be explained by the fact that the short rates were in minimum values in the last years as well as its volatility3, and for the long term bonds, the continuous open market operations performed by the Federal Reserve in the long term bonds. In summary, the analysis performed during this section shows an interesting way to immunize a bond portfolio to change in the yield curve using PCA, in such way that you can save transaction costs using only three assets to hedge the entire curve. However, it is important to take into account that this methodology could fail in periods characterized by interventions of the policy makers in the bond market or in ones with high volatility in the equity markets. It is important to emphasize that these the periods are the one when you most want your hedge to work. 5. Conclusions The principal component analysis is a powerful tool to explain the variability of a set of assets, in this case yields, with a combination of a few of them. In fact, in this analysis we have shown that we can explain on average approximately the 90% of the term structure of interest rates variability with only three components. Furthermore, for the interest rates, the first three components have a nice interpretation showing parallel shifts in the yield curve, and changes in its slope and shape. In addition, we have shown that not only the variability that these components can explain is not constant over time, but also that the participation of each component in the total variability depends on the particular period. In particular our analysis suggests that the structure of the principal components could be affected by high volatility in
3

The standard deviation of the short rates (3m and 6m) for the year 2011 was 0.009% against an average of 0.052% for the previous years. However, for the long rates (10yrs and 30yrs) the standard deviation was 0.065% against an average of 0.063%

the financial market or intervention of the policy makers, among others. These changes in the structure of the principal components also affect the interpretation of them, for example as we can see during 2008 the first PC didnt seem to explain parallel shifts any more. Finally, given that exogenous factors may affect the structure of the principal components over time, a good practice using this methodology would be resetting the parameters regularly. This recommendation applies especially in moments of crisis or periods of high uncertainty.