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FRM Part II · FRM Exam Part II · Regression Hedging and Principal Component Analysis

Which is a recognized limitation of using PCA factors from historical data to hedge a fixed income portfolio?

The main limitation is that components estimated from historical data may be unstable, so a hedge built on past co-movements can fail when relationships change. Components are uncorrelated by construction, and PCA handles many factors without needing normality or equal variances.

  1. APrincipal components are always correlated with each other, so exposures cannot be added
  2. BThe estimated components may be unstable over time and the hedge reflects only historically observed co-movementsCorrect
  3. CPCA cannot be applied to more than two risk factors
  4. DPCA requires the factors to be normally distributed with equal variance

Explanation

PCA components are uncorrelated by construction, and PCA works with many factors and does not require normality. Its weakness is that loadings estimated from history may change, so the hedge can fail when relationships shift.

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