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IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

Principal component analysis of historical yield curve changes typically finds that the first principal component is best interpreted as:

The first principal component is usually a roughly parallel shift in the level of the yield curve, explaining the largest share of variance. The second component typically represents slope and the third curvature.

  1. AA curvature or butterfly movement
  2. BA slope or steepening movement
  3. CA roughly parallel shift in the level of the curveCorrect
  4. DA change only in the shortest maturities
  5. Random noise unrelated to the curve

Explanation

Empirically, the first component explains most variation and has similar loadings across maturities, so it is a level shift. The second is slope and the third is curvature.

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