Using Principal Component Analysis to Explain Term Structure Movements: Performance and Stability Using Principal Component Analysis to Explain Term Structure Movements: Performance and Stability

This paper evaluates the performance of a kind of interest rate model that has increasingly been attracting the attention of the financial industry in recent years and which relies on principal component analysis to extract risk factors. Focusing on the Spanish bond market, our empirical analysis reveals that interest rate movements can be summarized by three principal components, related to the level, the steepness and the curvature of the yield curve. This three-principal component model is able to offer a balanced explanation of interest rate shocks and bond returns across maturities and overcomes typical oneand two-factor interest rate models. However, our results also reveal some variations with time in the principal components that point to the need to recognize the dynamic volatility structure of interest rates when dealing with factor models. JEL classification: E43; G12