YIELD CURVE ANALYSIS USING PRINCIPAL COMPONENTS

*Swamynathan V.

There has been a phenomenal slide in the
interest rates which has been of interest to
the corporates and academicians alike. To
put the facts in perspective, the following
graph depicts the level of the yield curve on
six sample dates:
same is then extended to delve on the
methodology to derive the sensitivity of a
portfolio of Fixed Income Securities to
change in interest rates.
What are the traits associated with a brand

Yield Curve Movement

12
11
S pot R a te (%)

10
03-Apr-01
9 01-Oct-01
8 01-Apr-02
01-Oct-02
7
01-Apr-03
6
01-Aug-03
5

4
1 Year 5 Year 7 Year 10 Year 15 Year 20 Year 25 Year 30 Year
Figure. 1

While the movement in the interest rates can like ‘Wheel’ of HLL?
be loosely explained in terms of a fall of
What are the features one desires when
around 400 bps. in the 10-year segment and
buying a C-Class car? What are the
the like, one is tempted to enquire about a
psychological traits that cause a person to
statistical framework to validate such
contribute to a charity institution?
developments.
Market research firms develop
The following note attempts to explore the
questionnaires seeking responses on
yield curve movement by introducing one of
personal background, social status, tastes,
the statistical methods used extensively. The
financial strength, et. al. to identify various

*Swamynathan V. is Assistant Manager, Risk Management,

The Clearing Corporation of India Limited.
factors that result in a person perceiving a
brand, preferring a particular feature of a car
or contributing selflessly to a social cause.
Factor Analysis – a stream in Statistical
research – is used widely to collate and
analyse responses and arrive at certain
common Factors which cause a particular
result. It’s a multi-variate statistical
technique for combining of seemingly
diverse material responses into few unique,
unrelated (and perhaps abstract) underlying
Factors.
The work on application of a technique of
Factor Analysis to yield curve movements is
credited to Robert, Litterman and
Sheinkman. The trio published an article
‘Common Factors Affecting Bond returns’
in the Journal of Finance (1991) employing
the technique of Principal Component
Analysis to the yield curve movements.
The Indian Sovereign yield curve starts from
the overnight rate and extends upto 30 years.
Every tenure may be considered as a Factor
which contributes towards the movement in
the yield curve; for the sake of convenience,
we may state that there are only 30 factors
(corresponding to the 30 tenures) which
effect the yield curve.
But we know that the movement in the
7.95% GS 2032 is related to the change in the
YTM of 6.01% GS 2028. The change in the
prices of the relatively illiquid securities in
the maturity bucket 7 to 12 years are driven
by the change in the YTM of the benchmark
security 7.37% GS 2014. This implies that:
while there may be 30 Factors (for the sake of
convenience) causing the daily movement in
the curve, there seems to be actually fewer
variables (Components) that drive the yield
curve. Hence, an effort has been made by us
to identify the underlying factors through
Principal Components Analysis (PCA).
The Principal Components Decomposition
is a particular kind of Factor Model. Its role
is to reduce the dimensionality of the subject
(in our case, the yield curve factors) i.e. to
reduce the number of underlying sources of
uncertainty or market factors. These factors
are not specified in advance; rather they are
derived out of the data analysed.
The number of Principal Components
derived from the yield curve analysis will be
equal to the number of factors which drive
the yield curve (i.e. 30 nos.). At first read, it
suggests that there may not be much
advantage using the PCA decomposition.
However, in the area of Finance, the data are
so highly correlated with each other that the
first few principal components explain most
of the variability of the yield curve.
Thenceforth, one may work with the
Principal Components which explain most
of the changes; than working with all the
causal factors.
Our analysis covers the change in yield curve
since Jan-2000 till Feb-2004, a period
spanning just over 3 years. The data yield
curve has been developed by the Nelson-
Siegel model.
We initiated a process to identify the Effect of Principal Components
0.6000
Principal Components in the Matlab
environment by feeding data of the 0.4000
yields of past 3 years. Instead of 30
yield points as factors as stated above, 0.2000

for the sake of our analysis, data

V a lue s
0.0000
relating to the yields of the tenures 0.5, 0.5 1 5 7 10 15 20 25 30

1, 5, 10, 15, 20, 25 and 30 years which is -0.2000

9 in number were entered in the

-0.4000
software. The software has derived 9
components (as expected, it’s equal to -0.6000
Tenures (Yrs.)
the number of tenure points of
Figure 2 PC1 PC2 PC3
analysis which is 9 in no.) which have
caused the movement in the yield curve. PCA also gives the contribution of
The effect of each of the components on each variability by the principal components to
tenure point of the yield curve is tabulated the yield movements.
below:
Table 1
PC1 PC2 PC3 PC4 PC5 PC6 PC7 PC8 PC9

0.5 Year -0.3102 -0.5499 -0.3851 0.4135 -0.4438 -0.2705 0.1037 0.0341 0.0094

1 Year -0.3080 -0.5151 -0.2529 -0.2214 0.5785 0.4026 -0.1632 -0.0570 -0.0164

5 Year -0.3260 -0.2159 0.3800 -0.5558 0.0082 -0.4078 0.3825 0.2626 0.1107

7 Year -0.3356 -0.0894 0.4473 -0.1055 -0.3108 0.0352 -0.4286 -0.5479 -0.2941

10 Year -0.3437 0.0548 0.3926 0.3133 -0.1470 0.4673 -0.1271 0.4614 0.3969

15 Year -0.3469 0.2034 0.1587 0.4152 0.3081 0.0616 0.5272 -0.0821 -0.5073

20 Year -0.3451 0.2866 -0.0798 0.1934 0.3357 -0.4006 -0.1192 -0.3696 0.5754

25 Year -0.3423 0.3373 -0.2748 -0.0989 0.0471 -0.2668 -0.4807 0.4851 -0.3795

30 Year -0.3396 0.3707 -0.4268 -0.3772 -0.3745 0.3788 0.3054 -0.1866 0.1048

It’s comforting to note that PC1 has
consistent negative values for all tenures.
PC2 has negative values for the shorter
tenures; it increases for the medium to
longer terms. PC3 has a negative impact on
the yield curve for the shorter and longer
tenures while its effect is positive for the
medium tenures.
PC1 contributes around 97.5% to the change
in the overall yield curve; followed by PC2 of
around 2.23%. The third component
changes the curve to the extent of 0.1%;
remaining components have a negligible
effect on the curve dynamics.
 Table 2 PC3 is the Curvature effect. It has an effect
similar to changing the curvature of the
Variance % Contribution Cum. Contribution
PC1 0.0037189000 0.9759 0.9759 curve of a day. This may be interpreted as the
PC2 0.0000849730 0.0223 0.9982 curve taking a longer (or shorter) time to
PC3 0.0000064787 0.0017 0.9999 reach the longest tenure rate.
PC4 0.0000002734 0.0001 1.0000
The values of the first three Components as
PC5 0.0000000364 0.0000 1.0000 rd
on 23 Feb’04 are as follows:
PC6 0.0000000028 0.0000 1.0000
Table 3
PC7 0.0000000001 0.0000 1.0000
Zero
PC8 0.0000000000 0.0000 1.0000 Tenures PC1 PC2 PC3
Rates
0.5 4.29% -0.3102 -0.5499 -0.3851
PC9 0.0000000000 0.0000 1.0000
1 4.34% -0.3080 -0.5151 -0.2529

We may, hence, conclude that the 5 4.91% -0.3260 -0.2159 0.3800

7 5.20% -0.3356 -0.0894 0.4473
dimensionality of the yield curve has even
10 5.56% -0.3437 0.0548 0.3926
got reduced from 9 to 2 (or 3). While we 15 6.01% -0.3469 0.2034 0.1587
haven’t assigned any name to the 20 6.29% -0.3451 0.2866 -0.0798

components, it is interesting to realize that 25 6.48% -0.3423 0.3373 -0.2748

PC1 effects a change in the level of the curve.
It has had a negative impact in the yield
curve in the past 3 years i.e. the fall in yield of
1 year (of 400 bps.) through 30 years (of 500
bps.) is explained by PC1 (parallel
movement) to the extent of 97.59%. From
Figure 2, the effect of PC1 is uniform across
the tenures indicating a parallel movement
in the curves. This is also diagrammatically
depicted in Figure 1.
PC2 can be considered as one that effects the
Slope of the curve. PC2 seems to cause a fall
in the short term (due to its negative values
in the shorter tenures) and a rise in the
longer term (due to the positive values in
Table 1). This is evident from the Figure 2.
where a dip in rates is observed in the shorter
term and rise in the longer term.
30 6.61% -0.3396 0.3707 -0.4268
-0.1664 0.0184 -0.0053
The Principal Components derived are
linear combinations of the variables (30
yield curve tenures) under study. Each
component is, thus, arrived at by the
summation of the products of the Zero Rates
and the contribution of the component to
the respective tenures.
To get an intuitive feel of the Principal
Components, we have plotted the effects of a
100 bps. change in the Components on the
yield curve of 23rd Feb’04 in Figure 3.
As is evident, PC1 results in a change in the
LEVEL of the curve; PC2 effects the SLOPE
of the curve; PC3 results in a change in the
CURVATURE of the curve.
 Figure 3
Component Effects
0.08
0.07
0.07
0.06
Ra te s (% )

0.06
0.05
0.05
0.04
0.04
0.03
1 2 3 4 5 6 7 8 9
Tenures
YC 23/02/04 YC shift due to PC1
YC shift due to PC2 YC shift due to PC3

A Risk Manager would be interested in using
the concept of PCA to arrive at the volatility
of a portfolio of fixed income securities.
One finds it convenient to deal with a
volatility matrix of 3 factors as compared to
a volatility matrix of 30 x 30.
We have tried to implement the PCA model
to a portfolio comprising of Zero Coupon
bonds - 25% of face value in a 1 year, 35% in 5
year and 40% in 20 year Zero coupon bonds
rd
based on the yields of 23 Feb, 2004. The
present value of the portfolio is as follows:
Table 4
Zero Rates 4.34%
Present Value (Rs.) 95.84
Portfolio weight 0.25
The sensitivity of the yield curve to changes
in the components is given by the respective
contributions to volatility of the Principal
Components as listed in Table 2.
Firstly, the change in the price of the bonds
for a 1 bp. change in each of the components
is computed. This is i.e. the change in the
price of the kth bond for a basis point
th
change in the i Principal Component. This
is similar to the Duration of a bond (which is
the change in a price of a security for a small
change in its yield). The values of b ki are
tabulated below for a 1 bp change in each of
the principal components.
It is notable that the effect of the change in
PC1 is all negative (LEVEL), change in slope
due to PC2 (SLOPE) and change in curvature
caused by PC3 (Curvature).
4.91% 6.29%
95.32 94.08 The Variance of the portfolio is derived
0.35 0.4 from the table above using the formula:
2 2 2
Portfolio Variance = b p1l1 + b p 2 l2 + b p 3 l3
Where l is the Variance of the respective
Principal Component.
The above equation can be regarded as a
product of the Duration and Volatility of a
bond to arrive at the risk exposure.
This results in the Variance of the portfolio
which can then be extended to arrive at the
Value-at-Risk figures. Assuming a Normal
Distribution, the VaR can, then, be
computed by adopting the parametric
method.
Conclusion
The Indian yield curve movement seems to
be a classical case for implementing PCA.
Our results have identified three factors
which can explain the change in the
complete yield curve. These factors can be
used to compute the Variance of a portfolio.
One may extend the implementation of PCA
to Stress a portfolio by changing the
Principal Components with respect to the
anticipation of yield changes in future.