global term structure modelling using principal component.pdfVIP

Global term structure modelling using principal component analysis Received (in revised form): 28th January, 2008 Arcady Novosyolov PhD is a Chief Scientific Adviser at FactSet Research Systems, Inc. Dr Novosyolov’s role at FactSet is to verify mathematical foundations of quantitative products and to help create solutions to critical questions in the field of risk measurement. He also teaches risk theory at Siberian Federal University. Founded in 1978, FactSet Research Systems, Inc. combines integrated financial information, analytical applications, and client service to enhance the workflow and productivity of the global investment community. Daniel Satchkovn CFA is Vice President at FactSet Research Systems, Inc. At FactSet he leads research and development of multi-asset class portfolio risk measurement products. Founded in 1978, FactSet Research Systems, Inc. combines integrated financial information, analytical applications, and client service to enhance the workflow and productivity of the global investment community. n E-mail: DSatchkov@ Abstract Principal component analysis (PCA) is a technique commonly applied to the interest rate markets to describe yield curve dynamics in a parsimonious manner. Despite an increase in global investing and the growing interconnectedness of the international markets, PCA has not been widely applied to decomposing joint structure of global yield curves. Our objective is to describe the joint structure with a model that can potentially be used for scenario analysis and for estimating the risk of interest rate-sensitive portfolios. In this study, we examine three variations of the PCA technique to decompose global yield curve and interest rate implied volatility structure. We conclude that global yield curve structure can be described with 15–20 factors, whereas implied volatility structure requires at least 20 global factors. The procedure that we identify as preferable is a two-step