FRM Part II · FRM Exam Part II · Regression Hedging and Principal Component Analysis
A analyst runs PCA on a yield curve covariance matrix. The first component has loadings of roughly +0.45 on every maturity, the second has loadings that move from negative at short maturities to positive at long maturities, and the third has a hump shape. Which interpretation is most appropriate?
The first component with equal positive loadings is a level (parallel shift) factor, the second with sign change across maturities is a slope factor, and the hump-shaped third is a curvature factor. These are the standard interpretations of yield curve PCA.
- ALevel, slope and curvature factors respectivelyCorrect
- BSlope, level and convexity factors respectively
- CParallel shift, volatility and credit spread factors respectively
- DCurvature, slope and level factors respectively
Explanation
Uniform same-sign loadings indicate a parallel shift (level). Loadings changing sign from short to long indicate a steepening/flattening (slope). A hump with opposite signs on wings and middle indicates curvature.
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