TABLE OF CONTENT

TABLE OF CONTENT
LIST OF FIGURE
LIST OF TABLE
INTRODUCTION .......................................................................................................... 1
CHAPTER 1: INTRODUCTION TO YIELD CURVE RISK MANAGEMENT ... 3
1.1. Yield curve ............................................................................................................ 3
1.1.1. Shape of yield curve ....................................................................................... 3
1.1.2. Type of yield curve ........................................................................................ 5
1.2. Yield curve risk management................................................................................ 5
1.2.1. Interest rate sensitivities measurement .......................................................... 5
1.2.2. Yield curve factor model ................................................................................ 9
1.2.3. Interest rate risk immunization .................................................................... 10
CHAPTER 2: REDUCED-FORM YIED CURVE MODELLING ......................... 16
2.1. Nonparametric approach the Principal analysis .................................................. 16
2.1.1. Statistical basis of Principal Component Analysis ...................................... 16
2.2. Parametric Approach The Nelson Sigel model ................................................... 27
2.2.1. Original model ............................................................................................. 27
2.2.2. The dynamic Nelson-Sigel model ................................................................ 31
2.2.3. State space model with Kalman Filter ......................................................... 32
2.3. Application to England Government Bond yield ................................................ 33


2.3.1. Data .............................................................................................................. 34
2.3.2. Estimating Parameter ................................................................................... 36
2.3.3. Dynamic modeling ....................................................................................... 43
2.3.4. Forecasting Interest rate ............................................................................... 46
CHAPTER 3: RISK SENSITIVITY AND IMMUNIZATION ............................... 58
3.1. Risk sensitivity .................................................................................................... 58
3.1.1. Reitano Partial Duration model .................................................................... 58
3.1.2. Example ........................................................................................................ 61
3.2. Factor duration models ........................................................................................ 63
3.2.1. PCA duration ............................................................................................... 63
3.2.2. NS duration based approach ........................................................................ 64
3.3. Immunization approaches ................................................................................... 65
3.3.1. Cash flow matching...................................................................................... 65
3.3.2. Traditional Duration Matching .................................................................... 65
3.3.3. Duration Vector Model ................................................................................ 66
3.3.4. Key rate immunization model ...................................................................... 68
3.3.5. Factor duration based immunization ............................................................ 71
3.4. Portfolio Optimization in immunization ............................................................. 71
3.5. An application to England Government Bond Data ........................................... 73
3.5.1. Portfolio Design ........................................................................................... 73
3.5.2. Result of portfolio optimization ................................................................... 77
CHAPTER 4: APPLICATION TO VIETNAMESE BOND MARKET ................ 83


4.1. Data ..................................................................................................................... 83
4.2. Yield curve modeling .......................................................................................... 83
4.3. Forecasting Yield curve ...................................................................................... 88
CHAPTER 5: CONCLUSIONS ................................................................................. 91
APPENDIX ................................................................................................................... 93
A. Mathematic Basis ............................................................................................. 93
B. Summary of Immunization Models Features .................................................. 97
C. Net Worth Immunization - Gap Analysis ......................................................... 99
REFERENCE ............................................................................................................. 104







LIST OF FIGURE
Figure 1.1: The US dollar yield curve as of February 9, 2005. The curve has a typical
upward sloping shape .......................................................................................................... 4
Figure 1.2: History of the term structure, USA, January 1990 February 2013................ 4
Figure 1.3: Illustration of target-date immunization ......................................................... 13
Figure 1.4: The Contingent Immunization ........................................................................ 14
Figure 2.1: Sensitivities of term structure with PCs ........................................................ 22
Figure 2.2: Variation of Eigenvalues with respective years (for all moving windows) ... 25
Figure 2.3: PC1 for all windows ....................................................................................... 26
Figure 2.4: PC2 for all windows (Standardized data) ....................................................... 27
Figure 2.5a,b,c: level, slope and curvature factor loading. ............................................... 29
Figure 2.6: Factor loading with fixed 0 0609 . = ............................................................. 30
Figure 2.7: Nominal Government Bond Yield Bank Of England ................................. 34
Figure 2.8: Actual and fitted average yield curve. ............................................................ 38
Figure 2.9: Selected tted (model-based) yield curves. .................................................... 38
Figure 2.10: Residual surface ............................................................................................ 40
Figure 2.11 a, b, c: The empirical level, slope and curvatures (red) and estimated
component factor
{ }
2 3 1

, ,
t t t
| | | (blue) ............................................................................. 42
Figure 2.12a,b,c: Autocorrelation
1

| ,
2

| ,
3

| ................................................................... 43
Figure 2.13a,b,c: Autocorrelation of residual
1 2 3
, , c c c .................................................... 45
Figure 2.14: RMSE comparison of seven methods........................................................... 56
Figure 2.15: Residual Autocorrelation of different methods ............................................ 57
Figure 3.1: Bond Price Change by Interest Rate Movements ........................................... 66
Figure 3.2: Yield curve shift at a key rate ......................................................................... 69
Figure 3.3: Yield curve shift in key rates .......................................................................... 70


Figure 4.1: PCA analysis of VN bond yield from 29/08/2008 to 8/7/2013 ...................... 84
Figure 4.2: Surface of VN bond yield ............................................................................... 85
Figure 4.3: Fitted yield curve at 29/08/2008 using mean data and mean estimated
parameters. ........................................................................................................................ 86
Figure 4.4: Fitted yield curve at selected date .................................................................. 87



LIST OF TABLE
Table 1.1: Benchmark yield curve of theoretical bond ........................................................8
Table 2.1: Principal Components for total period of all moving windows ....................20
Table 2.2: Principal Component factor weight statistical description of 1 month
moving windows ............................................................................................................21
Table 2.3: Eigenvalues for 1 and 3 month windows ......................................................... 23
Table 2.4: Eigenvalues for 6 and 12 month window ........................................................23
Table 2.5: Explanatory factor (%) of the first three principal components (6 month) .....24
Table 2.6: Descriptive statistics for monthly yields at different maturities and for the
yield curve level, slope and curvature. ..............................................................................35
Table 2.7: Statistical description of maturities minimizes curvature (third component).
PCA base on daily data of yields from 1990 2011 ........................................................36
Table 2.8: Descriptive statistic of
{ }
1 2 3
,

,

t t t
| | | using monthly yield data from
Jan1990Dec2011, with
t
xed at 42.2925.....................................................................37
Table 2.9: The Descriptive Statistic of model Residual ....................................................39
Table 2.10: The correlation between empirical slope, level curvature and
{ }
1 2 3

,

, | | | ..40
Table 2.11: The forecasted result comparison of seven methods. ....................................53
Table 2.12 P-value of test on mean error of RW forecast. ................................................54
Table 2.13: P-value of test on mean error of PCA forecast ..............................................55
Table 2.14 P-value of test on error mean of DNS AR forecast .......................................55
Table 2.15: P-value of test on error mean of DNS ARI forecast ......................................55
Table 2.16: P-value of test on error mean of Direct AR forecast .....................................55
Table 2.17 Dikey-Fuller test on estimated beta coefficient. .............................................58
Table 3.1: Yield curve of England Government Bond in 31/12/2006 ..............................74


Table 3.2: Portfolio designs ..............................................................................................75
Table 3.3: Correlation Matrix of Spot Rates Shifts ..........................................................76
Table 3.4: Portfolio allocation for Bullet Strategy ............................................................77
Table 3.5: Portfolio allocation for Laddering Strategy ....................................................77
Table 3.6: Portfolio allocation for Barbell Strategy ..........................................................78
Table 3.7: Change in benchmark yield curve ...................................................................79
Table 3.8: Surplus of each strategy in small change case .................................................80
Table 3.9: Surplus of each strategy in medium change case ............................................80
Table 3.10: Surplus of each strategy in extreme change case ...........................................80
Table 3.11: Surplus of each strategy in small change case (
6
10 ) ..................................81
Table 3.12: Surplus of each strategy in medium change case (
4
10 ) .............................81
Table 3.13: Surplus of each strategy in extreme change case (%) ....................................81
Table 4.1: Statistical Description of VN Bond Yield .......................................................85
Table 4.2: Statistical description of residual ....................................................................87
Table 4.3: Result of forecasted yield curve from 7 methods. Starred method means its
RMSE is lowest one in that case. ......................................................................................90

1

INTRODUCTION
Asset and liability management (often abbreviated ALM) is the practice of managing
risks that arise due to mismatches between the assets and liabilities in financial
intermediaries. Among many targets, ALM still focuses on interest rate risk and
liquidity risk because they represent majority loss in profit from financial operation.
Financial institutions managing fixed income portfolio of any types always have their
ultimate goal that is to keep a positive interest margin. This makes interest rate risk
management become a vital task in daily activity. Interest rate risk is defined as the risk
originated from change in interest rate that affects the value of interest bearing security.
In calculating this value; one usually uses a benchmark yield curve which is
interpolated from a universe of risk free bonds traded in the market. Therefore,
managing interest rate risk is to take into account the change in the total term structure
of interest rates (that is, yield curve).
Yield curve risk management is always attached to measure the sensitivity of
asset/liability value to change in the yield curve then hedge risk by matching it with
sensitivity of a benchmark portfolio or risk free asset. For example, in asset/liability
management, one controls the sensitivity of assets relative to fixed-income liabilities.
In total return fixed income management, one typically controls the sensitivity of the
asset portfolio relative to a fixed-income benchmark index which defines the
performance objective of the portfolio, finally, in fixed-income assets relative to a short
portfolio of fixed-income derivatives, such as interest rate future contracts.
Therefore, independent of the objective of the yield curve risk management program,
the first fundamental problem is to quantify the interest rate sensitivities of a given
fixed-income portfolio. The next fundamental problem is either to develop defensive
2

risk management strategies from a longer term model of yield curve movement. The
last fundamental problem relates to the development of yield curve models.
Traditionally, one usually uses duration model which bases on the parallel shift
assumption of yield curve, which is impractical. Many researches have been working
on relaxation of this assumption. However, on broadening the concept of duration to
meet that requirement, models usually use intuitive choice of parameter and become
highly dimensional, which increase the computational complexity. Reduced form
factor were another group of models with partially overcome these problem.
This thesis will introduce a general framework in addressing above fundamental
problems with relaxed assumption. The first chapter of this thesis will be a general
introduction on yield curve risk management. The second chapter will discuss about
yield curve model and forecast. The third chapter will focus on portfolio immunization.
Finally, we will apply these forecasting models to Vietnamese Bond Yield data.


3

CHAPTER 1: INTRODUCTION TO YIELD CURVE RISK MANAGEMENT
1.1. Yield curve
Yield curve present graphical interpretation of term structure of interest rates, as a
functional relationship between maturity of debt instruments of different length of time
to maturity and its yield to maturity.
1.1.1. Shape of the yield curve
As we can observe by analyzing yield curves in different markets at any time, a yield
curve can be one of four basic shapes, which are:
- Normal: in which yields are at average levels and the curve slopes gently
upwards as maturity increases;
- Upward sloping: in which yields are at historically low levels, with long rates
substantially greater than short rates;
- Downward sloping (or inverted) : in which yield levels are very high by
historical standards, but long-term yields are significantly lower than short rates;
- Humped: where yields are high with the curve rising to a peak in the medium-
term maturity area, and then sloping downwards at longer maturities.
On the three-dimensional plot (Fig. 1.2), we can see changes of yield curve shape for a
long period. The lower-right portion of the graph presents term structure for January
1990. The upper-left portion of the diagram presents term structure for February 2013.
The first term structure is upward sloping, with long-term yields above short-term
yields. The second is downward sloping, and is maintained by inverting the
relationship between short-term yields and long-term yields. The upward-sloping term
structures are more common than downward-sloping term structures, as it is obvious
from the figure.
4

Figure 1.1: The US dollar yield curve as of February 9, 2005. The curve has a typical
upward sloping shape (Source: Wikipedia)

Figure 1.2: History of the term structure, USA, January 1990 February 2013
5

1.1.2. Type of yield curve
1.1.2.1. Yield to maturity yield curve
The curve is constructed by plotting the yield to maturity against the term to maturity
for a group of bonds of the same class. The bonds used in constructing the curve will
only rarely have an exact number of whole years to redemption; however it is often
common to see yields plotted against whole years on the x-axis.
1.1.2.2. The par yield curve
The par yield curve plots yield to maturity against term to maturity for current bonds
trading at par. The par yield is, therefore, equal to the coupon rate for bonds priced at
par or near to par, as the yield to maturity for bonds priced exactly at par is equal to the
coupon rate.
1.1.2.3. The zero-coupon (or spot) yield curve
The zero-coupon (or spot) yield curve plots zero-coupon yields (or spot yields) against
term to maturity. The zero-coupon yield curve is also known as the term structure of
interest rates.
1.2. Yield curve risk management
As mentioned in the introduction, yield curve risk management has three fundamental
problems
1.2.1. Interest rate sensitivities measurement
Duration and convexity are main tools in measuring the interest rate sensitivity of fixed
income portfolio. Duration measure the change of bond price in response to interest
rate changes. Usually, if we calculate this change only proportionate to duration
measurement, the approximation will not bear good result as there is a certain
6

convexity in the value curve. The more curved the price function of the bond is, the
more inaccurate the valuation is. Convexity is a measure of the curvature of how the
price of a bond changes as the interest rate changes, i.e. how the duration of a bond
changes as the interest rate changes.
If we assume a smooth price function, duration can be formulated as the first derivative
of the bond price with respect to the interest rate, and then the convexity would be the
second derivative of the price function with respect to the interest rate. In this section,
the duration and convex analysis are based on a flat yield curve and parallel shift, this
assumption is far from the reality and will be relaxed later. However, both cases start
from the Taylors theorem below
Taylors theorem
( ) ( )
( )
( )
( )
( )
( )
( )
( )
( 1)
2 1
( ) ( 1)
If and its first ( 1) derivatives , , ... , are continuous on , .
Then it exists , such :
( ) ( ) ' " ...
2! ! 1 !
+
+
+
(

(

' '' +
e

= + + + + +
+
n
n n
n n
f n f f f a b
c a b
b a b a b a
f b f a b a f a f a f a f c
n n
The second order Taylor approximation gives the change in value derived from a
change in interest rates as

V
V y
y
c
A = A
c
(0.1)

2
2
2
1
2
( )
V V
V y y
y y
c c
A = A + A
c c
(0.2)
1.2.1.1. Duration
There are 2 different forms of Duration [30], [44]. We will start from the variation of
the price for an infinitesimal variation of interest
7


( )
1
1
1
1

n
t
t
t
t CF
V
y y
y
=

c
=
c +
+

(0.3)
Then

( )
( )
1
1
1
1

1
1
=
=

c
+
c
= = +
+
+

n
t
t
t
n
t
t
t
t CF
V
y
y
S
CF V y
y
(0.4)
Set
( )
( )
( )
1 1
1
1 1
1
1
( )
n n
t t
t t
t t
n
t
t
t
t CF t CF
y y
D S y
CF V
y
= =
=
+ +
= +

= =
+

We call D as Macaulay Duration and S the modified duration. The greater the duration
of a security, the greater the percentage change in the market value of the security for a
given change in interest rates. Therefore, the greater the duration of a security is, the
greater its interest-rate risks are. In the condition of continuous compounding of
interest rate, Macaulay Duration will equal modified duration.
1.2.1.2. The Convexity
The convexity measure of a security can be used to approximate the change in price
that is not explained by duration [30], [44]
( ) ( ) ( ) ( )
2
2
2 2 2
1 1
1 1
1 1 1 1
n n
t t
t t
t t
t CF t CF
V
y
y y y y
= =

c
= +
c
+ + + +

.
Then
8

( )
( )
( )
2
2
2 2
1
1
1 1
n
t t
t
t t
V
CF
y
y y
=
+
c
=
c
+ +

And

( )
( )
( )
2
2
2
1 2
1
1 1
n
t t
t
t t
CF V
y y
y
Conv
V V
=
+
c
+ +
c
= =

(0.5)
Conv is the percentage change of market value due to the convexity. The percentage
price change due to convexity is ( )
2
1
2
Conv dy .
1.2.1.3. An application
There is a 18Y bond with coupon rate 10% and will be paid annually. We assume a
parallel shift of yield curve by 5bp. The benchmark yield curve for this bond is
1Y-6Y (%) 6Y-12Y (%) 12Y-18Y (%)
5.1791 5.0972 5.0354
4.9749 4.9117 4.8471
4.7842 4.7257 4.6731
4.6261 4.584 4.5452
4.5085 4.4729 4.4377
4.4023 4.3667 4.3307
Table 1.1: Benchmark yield curve of theoretical bond
The present value of this bond is 167.3162805. As above formula uses univariate
model, therefore, we must find the yield maturity of this bond and use it as the discount
yield. We can use IRR function of Excel to do it.
9

(cash flow) = 4.475% y IRR =
Using (0.3) and (0.5), we can estimate the duration and convexity of this bond:
D=10.96087954 and C=154.4658629
Assume there is a parallel shift 5bp to the yield curve, the new present value is
166.4338992. We can approximate this value using (0.1) and (0.2), we achieve
166.3993137 and 166.4025443. Clearly, by combining with convexity, we get more
accurate result.
1.2.2. Yield curve factor model
Modeling the yield curve risk is an important part of a good risk management practice.
It is also a basic step to hedge a fixed income portfolio. As opposed to the class of no
arbitrage and equilibrium models, there are reduced-form models based on a statistical
approach, where interest rates are often modeled with a univariate time series or a
multivariate time series. The univariate class includes the random walk model, the
slope regression model, and the Fama-Bliss forward rate regression model (Fama and
Bliss, 1987), where interest rates are modeled for each term of maturity individually.
This class of models cannot, however, efficiently explore the cross-sectional
dependence of interest rates of different maturities for estimation and forecasting
purposes.
The multivariate class includes the vector autoregressive (VAR) [19] models and the
error correction models (ECMs), where interest rates of several maturities are
considered simultaneously to utilize the dependence structure and cointegration.
However, we cannot include all maturities to the model as this will increase the
dimension, this can be solved by selecting some key maturities in model. In that case,
this will reduce the comprehension of analyze process.
10

Therefore, the first problem faced in term structure modeling is how to summarize the
term structure information at any point in time. Yield curve models should employ a
structure that consists of a small set of factors and the associated factor loadings that
link yields of different maturities to those factors. Besides providing a useful
compression of information, a factor structure is also consistent with the celebrated
parsimony principle, which conducts the model following a broad sight, not to dig
deep in fitting model but increase the out-sample fitting. Parsimony is also a
consideration for determining the number of factors needed; along with the demands of
the precise application, for example in principal analysis, we can omit the remaining
component which only represents a small portion in variance.
This thesis will introduce two most common approaches. The first is principal
component analysis, a general approach places structure only on the estimated factors.
For example, the factors could be the first few principal components, which are
restricted to be mutually orthogonal, while the loadings are relatively unrestricted.
Indeed, the first three principal components typically closely match simple empirical
proxies for level (e.g., the long rate), slope (e.g., a long minus short rate), and curvature
(e.g., a mid-maturity rate minus a short and long rate average). The second approach is
a fitted Nelson-Siegel curve (introduced in Charles Nelson and Andrew Siegel, 1987)
[24]. In this thesis, we will apply this method under the dynamic form following the
work of Diebold and Li (2005) [9], this representation is effectively a dynamic three-
factor model of level, slope, and curvature.
1.2.3. Interest rate risk immunization
Traditional immunization focused on the concept of duration firstly introduced by
Macaulay (1938) for implementing immunization techniques, which work well on
parallel shift environment. These models relying on duration were targeting interest
11

rate risk and not really yield curve risk, since different points of the yield curve were
not allowed to move independently from each other as in the non-parallel world.
Klotz (1985) [18] made first step to move from generic interest rate risk to yield curve
risk with the introduction of the concept of convexity. Convexity is related to the
second derivative of the priceyield relationship of a bond. Later researches worked on
duration and convexity matching: socalled M-square and M-vector models were
introduced by Fong and Fabozzi (1985) [47-Appendix E], Chambers et al. (1988) [5],
and Nawalka and Chambers (1997) [23]. Another multifactor model which captures the
higher order of duration into account is duration vector (DV) models. An accurate
review of them is given in Nawalka et al (2003) [22], who also introduces a
generalization of the DV approach identified as generalized Duration vector (GDV).
A parallel development of immunization models relied on a statistical description of
the factors underlying yield curve shifts. This description was based on principal
component analysis (PCA). Barber and Cooper (1996) [1] adapted the duration model
of Fisher-Weil to estimate PCA duration then applied to fixed income portfolio
immunization. Jayathilaka, S. S. [16] also based on work of Cooper to develop a
duration immunization strategy on certain kind of fixed income portfolio.
A third class of widely used immunization models relies on the concept of key rate
duration (KRD) introduced by Ho (1992) [35]. These models explain yield curve shifts
based on a certain number of points along the curve the key rates and on linear
approximations based on time to maturity for the remaining rates.
Yield curve hedging techniques base on these duration models named immunization
approach. If we classify by the purpose of organization managing fixed income
portfolio we have net worth immunization and target date immunization, by managing
12

style there are passive and contingent immunization. Here we will go through these
mentioned types.
1.2.3.1. Net Worth Immunization
Net worth immunization approach is adopted by institutions that would like to reduce
variation in their net market worth, e.g. banks. There may be regulatory enforcement
regarding to keep a certain level of net worth in some type of financial institution.
Generally, this objective can be broadly achieved by ensuring that the duration of the
asset portfolio equal the duration of the liability portfolio if the present value of the
assets equals the present value of the liabilities. Gap analysis is used in net worth
immunization. This approach is adopted in institutions like banks. (see APPENDIX C)
1.2.3.2. Target Date Immunization
Not just that the net worth remains relatively constant, but bank and other institutions
like pension fund, insurance company also concern that each promised payment
(liability) be made on the appropriate date. Obviously, if each liability is immunized,
all liabilities together are also immunized. However, if net worth is immunized, each
liability by itself might not be immunized, and it would be necessary to depend upon
higher asset revaluations overall to make up shortfalls in the funding for particular
liabilities, this leads to the target date immunization.
The return of an asset calculated over a horizon equal to its duration is immune to any
interest rate variation. With fixed rate assets, obtaining the yield to maturity requires
holding the asset until maturity. When selling the asset before maturity, the return is
uncertain because the price at the date of sale is unknown. If rates increase, prices will
decrease, and vice versa.
13


Figure 1.3: Illustration of target-date immunization
The holding period return combines the current yield (the interest paid) and the capital
gain or loss at the end of the period. The total return from holding an asset depends on
the usage of intermediate interest ows. Investors might reinvest intermediate interest
payments at the prevailing market rate. The return, for a given horizon, results from the
capital gain or loss, plus the interest payments, and plus the proceeds of the
reinvestments of the intermediate flows up to this horizon. If the interest rate increases
during the holding period, there is a capital loss due to the decline in price,
simultaneously, intermediate flows benefit from a higher reinvestment rate up to the
horizon at a higher rate. If the interest rate decreases, there is a capital gain at the
horizon. At the same time, all intermediate reinvestment rates get lower. These two
effects tend to offset each other. There is some horizon such that the net effect on the
future value of the proceeds from holding the asset, the reinvestment of the
intermediate ows, plus the capital gain or loss cancels out. When this happens, the
future value at the horizon is immune to interest rate changes. This horizon is the
duration of the asset





time
14

1.2.3.3. Passive and contingent immunization
A portfolio manager may have a minimum portfolio value in mind at a pre-specified
horizon point. He has a switching regime: fully immunizes the portfolio and attains
the required minimum portfolio value at the horizon point, this is a passive
immunization. Alternatively, if he currently has a greater sum of money that is
required in order to attain that minimum value, he may choose a more active
approach: contingent immunization.

Figure 1.4: The Contingent Immunization
a) Triggering case b) Non Triggering case
Contingent immunization started from the work of Leibowitz and Weinberger (1981,
1982 and 1983) [36] [37]. It can be considered as a midpoint between passive
immunization and active bond management strategies. Contingent immunization is a
stop loss strategy that allows portfolio managers to take advantage of their ability to
forecast interest rate movements as long as their forecasts are successful, but switches
to a passive immunization strategy should the stop loss limit be encountered.
Specifically, contingent immunization consists of forming a bond portfolio with
duration larger or smaller than the investors planning period depending on interest

V
Horizon

V
Horizon
15

rate expectations. If the investor thinks that interest rates are going to rise more than
the market expects she would buy a bond portfolio with a duration D' smaller that her
planning period H and vice versa. However, if interest rates move opposite to the
investors expectations and the portfolio value falls to a given stop loss limit then she
would immunize and guarantee this lower limit for the eventual portfolio return. This
strategy gives contingent immunization an option like feature: limiting losses but
preserving upside potential if interest rates movements are favorable.


16

CHAPTER 2: REDUCED-FORM YIELD CURVE MODELLING
2.1. Nonparametric approach: the Principal analysis
2.1.1. Statistical basis of Principal Component Analysis
Principal Component Analysis (PCA) techniques can be employed to explore the
variability and correlations of various yields. PCA input is a set of N correlated series;
the input will be decomposed into N uncorrelated components, which are called
factors. In order to do so, the covariance structure is computed and its eigen-structure is
produced. The eigenvectors with the largest eigenvalues point towards the most
important factors, and can be utilized to investigate which proportion of the variability
of the original series is explained by individual factors. Typically, we expect a set of
factors that will explain 90-95% of the total variability.
Also, yields are strongly auto-correlated through time. It makes then perfect sense to
work with the time-differenced series: in essence the factors will then explain changes
in the yield curve behavior through time, rather than the yield curve level. We will
denote with ( ; ) y t t the yield of bond with maturity t , recorded at time 1 2 , ,.... t =
Therefore, each yield change 1 ( ; ) ; ) (
j j j
y t y y t t t A = is written as the weighted sum
of n factors [46]
1 1 , , ,
... ...
i n j j j j i j n
y c f f f + + + + A = +
The coefficients
, j i
are called factor loadings, and essentially determine the sensitivity
of yield
j
y to factor
i
f , and
j
c is a constant
j j
c y E = A . If we assume that the factors
are uncorrelated, and they are normalized with zero mean and unit variance, then we
can write the covariance of different yields as
17

1
, ,
( , )
b
j k j m k m
m
y Cov y
=
A A =

Therefore, if we denote with L the matrix that collects all factor loadings, then the
covariance matrix E of the yield changes will be equal to
LL E = '
Given that the covariance matrix is not singular, an eigen-decomposition will produce a
matrix V with the linearly independent eigenvectors, together with a diagonal matrix of
eigenvalues M, such that
1
VMV

E =
But as E is symmetric, the eigenvectors form an orthonormal matrix
1
V V

' = , which
implies essentially that the factor loadings matrix can be expressed as
L V M =
Using this representation we can write the yield changes in the terms of the elements of
the eigenvector matrix V and the eigenvalues in M
1 1 1 , , ,
... ...
j j j j i i i j n n n
c v m f v m f v m f y = + + + + + A
It is therefore intuitive that factors that are associated with higher eigenvalues will
contribute more to the total variability of the series. In particular, if we consider the
overall variance of all yields, then we can write as the sum of all eigenvalues.
2
1 1 1 1
,
( )
n n n n
j j i i j
j j i j
Var y v m m
= = = =
A = =


18

Where the last equality follows from the fact that the eigenvectors are normalized to
unit length. In factor analysis we use only the largest n eigenvalues, and implicitly the
contributions of the rest as being independent across all maturities
1 1 1 , , ,
... ...
j j j j i i i j n n n j
c v m f v m f v m y f q A = + + + + + +
The number of factors that we retain should be used as to make the variance of the
remainder component
j
q small. As a rule of thumb, n should ensure that at least 95%
of the total variance is explained by the corresponding factors. If one finds that such a
value of n is large compared to the total number of variables, it is evidence that factor
analysis might not appropriate for this case
1.1. Application to the Bank of England Data
To apply the model, I employ database of the England government bond nominal spot
rates, where it covers a time period starting from year 2000 to year 2013. There will be
50 evenly spaced maturities ranging from 0.5 to 25 year.
Data which comes as inputs to PCA should be stationary but data we are using here
will be like term structure of interest rates, prices or yields. Generally these factors are
non-stationary but the PCA is based on the stationary data, therefore these historical
data or original data must be transformed generally into returns. These returns should
be normalized before analyzing, if not the first principal component will be led by the
inputs with a greater instability.
We can normalize by estimate the z-score:
j j
i
j
y y
X
o
A A
=
19

To test the stability of PCA result, PCs are determined using the daily changes of
interest rate under different moving windows such as one month (M1), three months
(M3), semi-annually (M6) and yearly (M12). The correlation matrix has been found
using these data with daily changes of interest rate in relevant moving windows.
1 Month 3 months 6 months 12 months
0.065 0.280 0.511 0.064 0.287 0.537 0.063 0.290 0.543 0.062 0.289 0.543
0.096 0.303 0.260 0.096 0.315 0.289 0.095 0.324 0.309 0.095 0.325 0.319
0.110 0.277 0.123 0.110 0.293 0.146 0.110 0.304 0.162 0.110 0.306 0.168
0.118 0.248 0.051 0.118 0.268 0.067 0.118 0.279 0.079 0.118 0.281 0.081
0.124 0.226 0.012 0.124 0.245 0.020 0.124 0.255 0.028 0.123 0.257 0.027
0.128 0.204 -0.019 0.128 0.224 -0.016 0.128 0.234 -0.009 0.128 0.235 -0.011
0.131 0.186 -0.036 0.132 0.205 -0.036 0.132 0.215 -0.033 0.132 0.216 -0.036
0.135 0.167 -0.054 0.135 0.185 -0.058 0.135 0.194 -0.057 0.135 0.197 -0.058
0.137 0.149 -0.071 0.138 0.166 -0.080 0.138 0.175 -0.081 0.138 0.177 -0.082
0.140 0.133 -0.076 0.140 0.149 -0.087 0.140 0.157 -0.090 0.140 0.159 -0.092
0.141 0.114 -0.085 0.142 0.130 -0.100 0.142 0.138 -0.105 0.142 0.139 -0.107
0.143 0.098 -0.090 0.144 0.112 -0.106 0.144 0.119 -0.113 0.144 0.120 -0.116
0.144 0.082 -0.096 0.145 0.096 -0.115 0.145 0.103 -0.124 0.145 0.104 -0.126
0.145 0.069 -0.101 0.145 0.081 -0.120 0.146 0.087 -0.129 0.146 0.088 -0.131
0.146 0.057 -0.104 0.146 0.068 -0.123 0.146 0.074 -0.133 0.146 0.075 -0.136
0.146 0.045 -0.101 0.147 0.056 -0.123 0.147 0.060 -0.133 0.147 0.061 -0.135
0.147 0.034 -0.101 0.147 0.043 -0.125 0.147 0.047 -0.136 0.147 0.047 -0.139
0.147 0.023 -0.101 0.147 0.031 -0.123 0.147 0.035 -0.134 0.148 0.036 -0.136
0.147 0.014 -0.100 0.148 0.022 -0.121 0.148 0.025 -0.133 0.148 0.025 -0.135
0.148 0.006 -0.096 0.148 0.012 -0.116 0.148 0.015 -0.128 0.148 0.015 -0.130
0.148 -0.003 -0.090 0.148 0.003 -0.110 0.148 0.005 -0.121 0.148 0.005 -0.123
0.148 -0.009 -0.080 0.148 -0.005 -0.099 0.148 -0.003 -0.110 0.148 -0.003 -0.112
20

0.149 -0.016 -0.073 0.149 -0.012 -0.091 0.149 -0.011 -0.101 0.149 -0.012 -0.103
0.149 -0.023 -0.068 0.149 -0.020 -0.084 0.149 -0.019 -0.093 0.149 -0.020 -0.095
0.149 -0.028 -0.061 0.149 -0.026 -0.076 0.149 -0.026 -0.084 0.149 -0.027 -0.086
0.149 -0.035 -0.050 0.149 -0.035 -0.063 0.149 -0.035 -0.071 0.149 -0.036 -0.072
0.149 -0.040 -0.043 0.149 -0.041 -0.054 0.149 -0.042 -0.060 0.149 -0.043 -0.062
0.149 -0.046 -0.034 0.149 -0.048 -0.043 0.149 -0.049 -0.049 0.149 -0.050 -0.050
0.149 -0.052 -0.023 0.149 -0.056 -0.029 0.149 -0.057 -0.033 0.149 -0.058 -0.034
0.149 -0.056 -0.015 0.149 -0.060 -0.019 0.149 -0.063 -0.022 0.149 -0.063 -0.023
0.149 -0.061 -0.007 0.149 -0.067 -0.009 0.149 -0.070 -0.011 0.149 -0.070 -0.011
0.148 -0.066 0.002 0.148 -0.073 0.003 0.148 -0.076 0.003 0.149 -0.076 0.003
0.148 -0.070 0.012 0.148 -0.078 0.014 0.148 -0.082 0.016 0.148 -0.083 0.016
0.148 -0.074 0.020 0.148 -0.083 0.022 0.148 -0.088 0.024 0.148 -0.088 0.024
0.147 -0.079 0.030 0.147 -0.090 0.035 0.147 -0.094 0.038 0.147 -0.095 0.039
0.147 -0.083 0.036 0.147 -0.094 0.044 0.147 -0.099 0.049 0.147 -0.100 0.049
0.146 -0.087 0.047 0.146 -0.099 0.056 0.147 -0.104 0.062 0.147 -0.105 0.063
0.146 -0.090 0.054 0.146 -0.103 0.065 0.146 -0.109 0.071 0.146 -0.110 0.072
0.146 -0.094 0.059 0.146 -0.107 0.072 0.146 -0.114 0.080 0.146 -0.114 0.081
0.145 -0.097 0.067 0.145 -0.111 0.083 0.145 -0.118 0.090 0.145 -0.119 0.092
0.145 -0.100 0.072 0.145 -0.115 0.090 0.145 -0.122 0.098 0.145 -0.122 0.100
0.144 -0.103 0.082 0.144 -0.119 0.100 0.144 -0.126 0.109 0.144 -0.126 0.110
0.144 -0.105 0.085 0.144 -0.122 0.105 0.144 -0.129 0.114 0.144 -0.130 0.116
0.143 -0.108 0.091 0.143 -0.125 0.112 0.143 -0.133 0.122 0.143 -0.133 0.124
0.143 -0.110 0.092 0.143 -0.128 0.116 0.143 -0.136 0.126 0.143 -0.136 0.128
0.142 -0.113 0.098 0.142 -0.131 0.122 0.142 -0.140 0.132 0.142 -0.140 0.135
0.141 -0.115 0.101 0.142 -0.134 0.125 0.142 -0.142 0.136 0.142 -0.142 0.139
0.141 -0.117 0.106 0.141 -0.136 0.131 0.141 -0.145 0.142 0.141 -0.145 0.145
0.141 -0.118 0.108 0.141 -0.138 0.134 0.141 -0.147 0.146 0.141 -0.147 0.149
0.140 -0.120 0.111 0.140 -0.140 0.139 0.140 -0.149 0.151 0.140 -0.149 0.154
Table 2.1: Principal Components for total period of all moving windows
Table 2.1 shows the principal components for total period of all moving window, The
first component eigenvector is shown in the first, forth, seventh and tenth columns.
21

Exclude several first rows, the remaining values varies in a narrow band ranging from
0.13 to 0.153. Although this is relative flat in comparison with last two components.
Component Shape Max Min Standard Deviation
1 Flat 0.149 0.065 0.015
2 Steepness 0.303 -0.120 0.122
3 Curvature 0.511 -0.104 0.109
Table 2.2: Principal Component factor weight statistical description of 1 month moving
windows
From table 2.2, we can confirm this flat characteristic of first component through the
standard deviation of factor weights of each component as the first component has the
smallest one. And this result is similar to other moving window. The second
component factor weights almost monotonically decreases from 0.303 to -0.12.
Third principal component, factor weights are positive in the short maturity and when
the maturity dates goes up it decreases and the middle part of the term structure gives
negative values where it becomes positive in the longer maturity years. This third
principal component corresponds to the curvature. The above description is based on
the one month moving window. With three months or six months moving windows, the
value may slightly change but the shape of the PCs will not change. Three main
components of one month window are plot in figure 2.1, from this we can clearly see
the shape of these components.
The first component can be interpreted as the parallel shift of yield curve, hedging
against Factor 1 is therefore close to duration hedging, which is denoted as the level
factor. PC1 is the most important component to explain the term structure movements,
table 2.3 gives the average eigenvalue for each moving window in each year and table
2.4 is the correspondent percentage of variation explanation of each component. The
22

one month window eigenvalue of first component is 41.01 and it explains 88.01% of
the total variation.

Figure 2.1: Sensitivities of term structure with PCs
Maturity
1 month 3 months
1

2

3

1

2

3

2000 41.02 6.26 1.63 41.28 5.80 1.77
2001 40.71 7.03 1.26 40.90 6.76 1.30
2002 45.19 3.39 0.65 45.31 3.16 0.67
2003 43.98 4.45 0.91 43.79 4.36 1.17
2004 45.29 3.17 0.60 45.40 3.00 0.56
2005 45.78 3.04 0.59 46.09 2.77 0.55
2006 45.06 3.71 0.62 45.08 3.69 0.62
23

2007 44.80 3.83 0.70 44.84 3.72 0.65
2008 44.16 4.60 0.83 44.19 4.56 0.76
2009 42.58 5.17 1.60 42.04 5.46 1.74
2010 44.68 3.61 1.00 44.41 3.75 1.00
2011 44.53 3.70 1.12 44.70 3.42 1.22
2012 44.30 3.26 1.32 44.44 2.94 1.27
Table 2.3: Eigenvalues for 1 and 3 month windows
Maturity
6 months 12 months
1

2

3

1

2

3

2000 41.17 5.80 1.90 41.61 5.47 1.62
2001 41.38 6.26 1.31 41.79 6.05 1.13
2002 45.40 2.99 0.72 44.94 3.53 0.63
2003 43.62 4.37 1.31 43.71 4.14 1.40
2004 45.46 2.96 0.52 45.19 3.19 0.55
2005 46.11 2.76 0.58 45.75 3.02 0.62
2006 45.26 3.52 0.65 44.91 3.76 0.67
2007 45.01 3.62 0.61 45.31 3.33 0.65
2008 43.93 4.77 0.78 43.47 4.81 0.98
2009 41.67 5.72 1.79 41.70 5.98 1.47
2010 44.31 3.76 1.05 44.79 3.31 1.03
2011 44.39 3.59 1.37 43.44 4.51 1.39
2012 44.11 3.11 1.33 43.93 3.19 1.34
Table 2.4: Eigenvalues for 6 and 12 month window

24

M1 M2 M3 M4
2000 82.04 12.51 3.27 82.57 11.60 3.55 82.33 11.59 3.80 83.21 10.95 3.24
2001 81.41 14.07 2.51 81.79 13.52 2.60 82.77 12.52 2.63 83.58 12.10 2.27
2002 90.37 6.78 1.29 90.63 6.31 1.33 90.81 5.98 1.43 89.89 7.05 1.25
2003 87.96 8.90 1.81 87.57 8.72 2.34 87.25 8.74 2.62 87.41 8.28 2.81
2004 90.58 6.34 1.20 90.79 6.00 1.12 90.92 5.93 1.03 90.38 6.37 1.11
2005 91.57 6.08 1.19 92.17 5.55 1.10 92.23 5.51 1.16 91.49 6.04 1.23
2006 90.12 7.42 1.24 90.17 7.39 1.23 90.52 7.03 1.30 89.83 7.53 1.35
2007 89.60 7.67 1.40 89.68 7.44 1.31 90.03 7.25 1.23 90.63 6.65 1.31
2008 88.31 9.21 1.67 88.38 9.12 1.52 87.86 9.54 1.55 86.94 9.62 1.97
2009 85.17 10.33 3.19 84.08 10.93 3.47 83.34 11.44 3.58 83.40 11.95 2.93
2010 89.37 7.22 2.00 88.82 7.49 2.00 88.63 7.53 2.10 89.58 6.63 2.06
2011 89.07 7.41 2.24 89.40 6.85 2.43 88.78 7.18 2.73 86.88 9.03 2.78
2012 88.61 6.51 2.64 88.87 5.88 2.53 88.22 6.23 2.66 87.86 6.37 2.67
Table 2.5: Explanatory factor (%) of the first three principal components (6 month)
For the second principal component factor, steepness has opposite effects to the short
term maturity and long term maturity. As the value of the PC2 increases, the term
structure of short maturity increases and long term maturity decreases.
The third eigenvector corresponds to Curvature factor and the reason is that it has
reduced the middle term structure while increasing the short maturity and long maturity
term structures. Because of that, the curvature of the term structure depends on this
third principal component. The third principal component is relatively not very
important and the total variation explained by the PC3 is 3.27 percent for the total time
period concerned.
25


Figure 2.2: Variation of the Eigenvalues with respective years (for all moving windows)
From figure 2.2, the eigenvalues of each component are almost stable through thirteen
years, with a slightly increase of the first component and decrease of the second one.
The third component is the most stable. This again confirms the importance of first
component. Any 3 factor model bases on these components should bear a good
analysis result. Immunization that bases on parallel assumption therefore is still
meaningful.
Figure 2.3 and 2.4 plot the first and second component average factor weight for 3
moving window. From this we can see that, the factor weight remain unchanged in any
26

specific time frame. For the second component, the larger the moving window is, the
more the short-term rate increases, the long-term rate decreases. But in general, the
shapes of steepness factor are the same.

Figure 2.3: PC1 for all windows
27


Figure 2.4: PC2 for all windows (Standardized data)
2.2. Parametric Approach: The Nelson Sigel model
2.2.1. Original model
We look into the two main variants of the model, namely the original formulation of
Nelson and Siegel (1987) [24], and the Dynamic one developed by Diebold Li (2006)
[9].
Nelson and Siegel (1987) suggested modeling the yield curve at a point in time as
follows: let ( ) y t be the zero rate for maturityt , then
28

1
2 1 3
1 1
st
nd rd
2 component co
component
mponent 3
ex / / )
) / )
p( ) exp(
( exp(
/ /
y
t t
t |

| t

|
t t
( (
+ +
( (

=
Thus, for given a given cross-section of yields, we need to estimate four parameters:
1 2 3
, , | | | and . For m observed yields with different maturities
1
t ,,
m
t , we have m
equations. There is a simple strategy to obtain parameters for this model: x , and
then estimate the | -values with Least Squares.
In this model, the yield y for a particular maturity is hence the sum of several
components.
In first component, factor loading on
1
| is one, it is independent of time to maturity
and interpreted as the long-run yield level.
In second component, factor loading on
2
| is
1

/
e
/
t
t

, a function of time to maturity.

It starts at 1 but decays monotonically and quickly to 0, hence the influence of
2
| is
only felt at the short-end of the yield curve, it can be consider as a short-term factor.
Factor loading on
3
| is
1

/
/
e
/
t
t
e
t

and also a function of t , but this function is

zero for 0 t = , increases, and then decreases back to zero as t grows. It thus adds a
hump to the curve.
The parameter affects the weight functions for
2
| and
3
| ; in particular does it
determine the position of the hump. An example is shown figure 2.1.a to 2.1.c. The
parameters of the model thus have, to some extent, a direct (observable) interpretation,
which brings about the constraints
1
0 | > ,
1 2
0 | | + > . We also need to have 0 > .
29





Figure 2.5a: Level. The left graph shows
1
3 ( ) y t | = = . The right graph shows the
corresponding yield curve, in this case also
1
3 ( ) y t | = = . The influence of
1
| is constant
for all t
Figure 2.2b: Short-end shift. The left graph shows
2
1 exp(
)
/ )
(
/
y
t
|
t
t

=
(

for
2
2 | = . The right graph shows the yield curve resulting from the effects of
1
| and
2
| , i.e.,
1 2
exp( /
)
/
)
( y
t
t | |
t
( 1
= +
(

for
1
3 | = ,
2
2 | = . The short-end is shifted down by
2%, but then curve grows back to the long-run level of 3%.
2
0
4
0 5 10
Y
i
e
l
d

i
n

%

Component
2
0
4
0 5 10
Resulting yield curve
0
-2
4
5
10
Y
i
e
l
d

i
n

%

Component
2
0
4
0 5 10
Resulting yield curve
30

Figure 2.5c: Hump. The left graph shows
3
1 exp( / )
exp( / )
/
t
| t
t
(

(

for
3
6 | = .
The right graph shows the yield curve resulting from all three components. In all graphs, value
of is 2.
We plot three factors on figure 2.6 below:

Figure 2.6: factor loading with fixed 0 0609 . =
2
0
4
0 5 10
Y
i
e
l
d

i
n

%

Component
2
0
4
0 5 10
Resulting yield curve
31

2.2.2. The dynamic Nelson-Sigel model
Recall the original model above:
1 2 3
1 1

| | | |

= + +
| |
\ . \ .
/ /
/
( )
/ /
e e
y e
t t
t
t | | |
t t

A dynamic version is required to understand the evolution of the bond market over
time. Hence Diebold and Li (2006) suggest allowing the | coecients to vary over
time, resulting in:
1 2 3
1 1
/ /
/
/ /
( )
t t t
e e
y e
t t
t
t t
t | | |

| | | |

= + +
| |
\ . \ .
,
in which case they show that, given their Nelson-Sigel loadings, the coefficients may
be interpreted as time-varying level, slope and curvature factors.
We can use AR(1) process or VAR(1) model to specify the dynamic of these
coefficients. In matrix notation, both are formulated:
1
( )
t t t
X AX I Au N

= + +
Where
C is a constant and
( )
0,
t
N Q
1
2
3
t
t
t
t
X
|
|
|
(
(
(
=
(
(

,
1
2
2
( )
( )
( )
t
t t
t
N
q |
q |
q |
(
(
(
=
(
(

,
3
1
2
u
|
|
|

(
(
(
=
(
(
(


For AR(1) model,
32


2
33
11
2
0 0
0 0
0 0
a
A a
a
(
(
=
(
(

,
2
2
3
11
2
3
2
2
0 0
0 0
0 0
q
Q q
q
(
(
=
(
(


VAR(1) model
11 12 13
21 22 23
31 32 33
a a a
A a a a
a a a
(
(
=
(
(

' Q qq = where
22
31 32
1
3
21
3
1
0 0
0
q
q q q
q q q
(
(
=
(
(


2.2.3. State space model with Kalman Filter
The Kalman Filter is an iterative estimation algorithm designed to solve the problem of
estimating state variables of a linear dynamical system with unobservable data. This is
typically done by writing the model in terms of a linear state-space representation (or a
linear dynamical system). The state-space representation means formulating two
equations, a transition and measurement equation.[4]
The measurement is
0 , ( , )
t t t t
R BX E E H = +
And the transition equation is
1
0 ( ( , ) ) ,
t t t t
X AX I A u N N Q

= + +
Having specified the state-space representation, the focus turns to the algorithm. The
optimal estimator in a Kalman Filter is the conditional mean of
t
X independent on
information known up to time t-1 or t, denoted
1 | t t
X

and
| t t
X respectively.
33

Using the transition equation, the recursive prediction step can be calculated as, where
information up until time t-1 is known

1 1 1 |
[ ] ( )
t t t t t
X E X AX I Au

= = +
Encumbered with mean square error matrix (again the predictive step)

( )( )
| 1 1 | 1 | 1 1
'

(
E = = E ' +
(

t t t t t t t t t t
X X X X A A Q
Using the measurement equation these estimates can be improved by observing
t
R and
using its addition information (the update step)
1
1 1 | | |
[ ]
t t t t t t t t t t
X X X X B B F v

= = '
( ) ( )
1
1 1 1 | | | | | t t t t t t t t t t t t t t t
X X X B F X B

(
'
E = = E E E
(

'

With the forecasting errors being
1 | t t t t
v R BX

=
With variance
1 |
( )
t t t t
Var v F B H B

= = E ' +
The Kalman Filter iterative process begins with
0
X and
0
E being set at the
unconditional mean and co-variance. We can estimate parameters by using Kalman
Filter Maximum-Likelihood. More about this method can be found in Appendix A.
2.3. Application to England Government Bond yield
34

2.3.1. Data
Continue with the data from end of month England government bond yield but we will
sample a different maturity set: 1Y, 2Y, 3Y, 4Y 5Y, 6Y, 7Y, 8Y, 9Y, 10Y, 11Y, 12Y,
13Y, 14Y, 15Y, 16Y, 17Y, 18Y from 01/1990 to 12/2011, leading to 258 observations
of monthly yield.

Figure 2.7: Nominal Government Bond Yield Bank Of England
Figure 2.7 plot the yield surface of data, there is a general decrease in yield level from
1990 to 2011. The yield curve in general has shown a persistent flat shape through
years before the upward sloping trend emerges from 2006 2011. We can predict a
low variation of curvature factor.
35

Maturity
(Months)
Mean
Standard
Deviation
Min Max 1 ( ) 6 ( ) 12 ( ) 24 ( )
12 5.348 2.838 0.376 14.311 0.972 0.797 0.616 0.328
24 5.481 2.662 0.328 13.725 0.972 0.803 0.644 0.395
36 5.616 2.548 0.487 13.315 0.973 0.812 0.666 0.440
48 5.723 2.467 0.733 13.075 0.974 0.821 0.684 0.472
60 5.806 2.404 1.001 12.932 0.975 0.828 0.698 0.496
72 5.870 2.352 1.264 12.828 0.976 0.834 0.710 0.516
84 5.919 2.306 1.510 12.733 0.976 0.839 0.720 0.533
96 5.955 2.264 1.733 12.629 0.977 0.845 0.729 0.547
108 5.981 2.225 1.931 12.508 0.977 0.850 0.737 0.560
120 5.999 2.189 2.105 12.368 0.978 0.855 0.745 0.571
132 6.010 2.156 2.257 12.211 0.978 0.860 0.753 0.582
144 6.016 2.125 2.390 12.039 0.979 0.865 0.761 0.592
156 6.017 2.096 2.507 11.855 0.980 0.870 0.769 0.601
168 6.013 2.069 2.611 11.663 0.980 0.874 0.776 0.609
180 6.005 2.045 2.703 11.465 0.981 0.879 0.783 0.617
192 5.994 2.023 2.786 11.263 0.982 0.883 0.790 0.624
204 5.980 2.003 2.861 11.059 0.982 0.887 0.796 0.631
216 5.963 1.984 2.929 10.854 0.983 0.891 0.802 0.638
Level 5.963 1.984 2.929 10.854 0.983 0.891 0.802 0.638
Slope 0.615 1.777 -4.182 4.121 0.966 0.750 0.513 0.081
Curvature 0.301 0.695 -1.303 2.988 0.923 0.485 0.141 0.022
Table 2.6: Descriptive statistics for monthly yields at different maturities and for the
yield curve level, slope and curvature. The last three columns contain the sample
autocorrelations at lag 1, 12, 30 months.
From the statistical description, the major trend is upward sloping by the mean of
yields through years, and that the long rates are less volatile and more persistent than
short rates, and it is even more stable if we consider that long-term means are smaller
than short term ones, that the slope is less persistent than any individual yield but quite
36

highly variable relative to its mean, and the curvature is the least persistent of all
factors and the most highly variable relative to its mean.
2.3.2. Estimating Parameter
Initially, Nelson and Siegel use a grid of value for . Which each value of , we can
calculate the values of two loading. The estimation of beta coefficient will then become
linear regression.
In Diebold-Li work, they instead work with a unique value of that maximizes the
loading on curvature component. This not only makes the study ahead simple and
convenient, but also numerical trustworthiness, by enabling us to replace hundreds of
potentially challenging numerical optimizations with trivial least-squares regressions.
Of course, we must choose the most appropriate value of . Recall that determines
the maturity at which the loading on the medium-term or curvature, factor achieves it
maximum.
Moving window Mean (Year) Median (Year) Mode (Year)
1 month 6.3522 5 6
3 month 6.0791 7 6
6 month 6.2202 7 6
12 month 6.3202 8 7
Table 2.7: Statistical description of maturities minimizes curvature (third component).
PCA base on daily data of yields from 1990 2011
From PCA result, we can find the maturities that maximize loading on curvature on
each sample. Table 2.6 gives the statistical description of these values. We choose the
mean of these maturities of 1 month case. The value of lambda that maximizes loading
at 6 month is 42.2925.
37

Using the empirical formula to estimate these feature of yield curve:
18 ( )
t
l y =
18 1 ( ) ( )
t
s y y =
18 1 2 ( ) ( ) ( )
t
c y x y y ( = +


Where
t
l ,
t
s ,
t
c are empirical level, slope, curvature at time t. In the curvature
empirical, x is a medium-term yield. We choose 5 x = . Then:

2 3
0.6762 + 0.0703
t t t
s | | = (2.1)

2 3
0 0026 . 0.2786
t t t
c | | = + (2.2)
We use these empirical values as a benchmark to check whether
{ }
1 2 3
,

,

t t t
| | | are
corresponding to the level, slope and curvature of model.
Mean Standard
Deviation
Min Max 1 ( ) 8 ( ) 20 ( )
6.0559 1.9393 2.9751 10.2630 0.9834 0.8995 0.7931
-1.0395 2.4980 -6.4450 5.1675 0.9653 0.7551 0.5313
0.7718 2.4491 -5.5818 8.9322 0.9306 0.5161 0.1934
Table 2.8: Descriptive statistic of
{ }
1 2 3
,

,

t t t
| | | using monthly yield data from Jan1990
Dec2011, with
t
xed at 42.2925
38


Figure 2.8: Actual and fitted average yield curve.

Figure 2.9: Fitting selected day of yield curves.
39

From figure 2.8, 2.9, the model can replicate different shape of yield curve including
upward sloping, downward sloping, humped , except for period with many local
extremes.
Maturity
(Months)
Mean Std.Dev Min Max MAE RMSE 1 ( ) 8 ( ) 20 ( )
12 0.042 0.091 -0.174 0.463 0.065 0.042 0.899 0.461 0.072
24 -0.028 0.062 -0.281 0.106 0.047 0.028 0.886 0.453 0.161
36 -0.034 0.085 -0.428 0.198 0.058 0.034 0.903 0.449 0.020
48 -0.027 0.066 -0.335 0.170 0.042 0.027 0.894 0.400 -0.057
60 -0.015 0.034 -0.176 0.075 0.022 0.015 0.861 0.290 -0.144
72 -0.002 0.015 -0.046 0.040 0.012 0.002 0.810 0.141 -0.058
84 0.010 0.034 -0.102 0.158 0.023 0.010 0.893 0.408 0.020
96 0.019 0.052 -0.142 0.259 0.034 0.019 0.893 0.415 -0.009
108 0.026 0.061 -0.150 0.312 0.040 0.026 0.890 0.412 -0.020
120 0.029 0.062 -0.133 0.323 0.041 0.029 0.888 0.410 -0.024
132 0.029 0.056 -0.099 0.296 0.038 0.029 0.887 0.409 -0.024
144 0.026 0.045 -0.058 0.238 0.031 0.026 0.886 0.408 -0.024
156 0.020 0.029 -0.028 0.158 0.022 0.020 0.883 0.399 -0.026
168 0.010 0.011 -0.011 0.069 0.011 0.010 0.833 0.305 -0.067
180 -0.002 0.016 -0.063 0.057 0.011 0.002 0.857 0.375 -0.034
192 -0.017 0.038 -0.192 0.084 0.025 0.017 0.888 0.422 -0.013
204 -0.034 0.062 -0.331 0.102 0.042 0.034 0.894 0.431 -0.009
216 -0.053 0.086 -0.476 0.113 0.061 0.053 0.898 0.437 -0.007
Table 2.9: The Descriptive Statistic of model Residual
The residual surface shows a turbulent in initial period, however, residual becomes
stable later without extreme value. We move on to consider the correlation between
empirical slope, curvature and level and estimated ones. Figure 2.11 a, b, c plot these
40

values in pairs and for the ease of comparison, we modified
2 3 1

, , | | | according to
(2.1) (2.2) but omit the small term.

Figure 2.10: Residual surface

1

t
|
2

t
|
3

t
|
t
l
0.9560 0.0968 0.1262
t
s
0.1028 -0.9956 0.0609
t
c
0.3510 -0.3599 0.9467
Table 2.10: The correlation between empirical slope, level curvature and

{ }
1 2 3

,

, | | |
41

The correlation between estimated component factors and empirical slope, level and
curvature, benchmark values we initially defined, are very high. Therefore the three
factors in our model correspond to level, slope and curvature.

Figure 2.11a: The empirical level (red) and estimated component factor
{ }
1

t
| (blue)

42


Figure 2.12b, c: The empirical slope and curvatures (red) and estimated component
factor
{ }
2 3

,
t t
| | (blue)
43

2.3.3. Dynamic modeling
We use AR(1) to model the dynamic of component factors. To check the fitness of the
model, many aspects should be checked.
Recall table 3.4, from the autocorrelations of the three factors, we can see that the rst
factor is the most persistent, and that the second factor is more persistent than the third.
From figure 2.12 a, b, c, the AR(1) model succeeds to preserve this persistency
characteristic of the 3 component factors.

Figure 2.13a: Autocorrelation
1

|
44

Figure 2.12b: Autocorrelation
2

|

Figure 2.12c: Autocorrelation
3

|
45


Figure 2.14a: Autocorrelation of residual
1
c

Figure 2.13b: Autocorrelation of residual
2
c
46


Figure 2.13c: Autocorrelation of residual
2
c
Figures 2.13 a, b, c have shown residual autocorrelation of estimated level, slope and
curvature factors. The autocorrelations are very small, indicating that the models
accurately describe the conditional means of level, slope and curvature.
2.3.4. Forecast Interest rate
In this section, we will forecast yields using three factor NS model with underlying
dynamic component factors stylized by the AR(1), VAR(1) ARI(1,1). Besides, several
different methods will be employed to compare with results using NS model. These
methods are:
- Random walk without drift
) ( ( )
t h t
y y t t
+
=
47

The forecast is always no change
- Direct regression on three AR(1) principal component.
The PCA will be carried on the yield data instead of yield change. We define
i it t
x f y = '
i=1, 2, 3. Then we use a univariate AR(1) model to produce a h-step-ahead forecast of
the principal components:
, /

i t h t i i it
c x x
+
= + , i=1, 2, 3
Then the forecasted yield can be produced as:
1 2 2 3 3 1 , / / / , , /
( ) ( ) ( ) ( )
t h t t t h t t h t t h
f x f x y x f t t t t
+ + + +
= + + ,
Where
1
( ) f t is the element in the eigenvector
i
q that corresponds to maturityt .
- AR(1), ARI(1) and VAR(1) on yields
These methods forecast directly yields.
Below is the result of forecast
Case Method Mean
Std
dev
AME RMSE ( ) a ( ) b
R-
square
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

RW -0.0692 0.2640 0.1477 0.2711 0.6748 0.1236 0.9830
PCA* -0.0270 0.2712 0.1519 0.2706 0.6760 0.0716 0.9831
DNSAR(1) -0.0437 0.2883 0.1662 0.2895 0.7021 0.0462 0.9806
DNSARI(1) 0.0597 0.2729 0.2004 0.2774 0.5944 0.0851 0.9822
DNSVAR(1) -0.1425 0.3184 0.2144 0.3468 0.7536 0.1408 0.9722
48

AR(1) -0.0855 0.2656 0.1536 0.2772 0.6776 0.1131 0.9820
VAR(1) -0.2565 0.3071 0.2700 0.3984 0.7563 0.2959 0.9616
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

RW -0.2210 0.6823 0.3651 0.7124 -0.3055 -0.1869 0.8762
PCA -0.2027 0.6806 0.3840 0.7054 -0.2873 -0.2289 0.8786
DNSAR(1)* -0.2884 0.6878 0.4436 0.7411 -0.2405 -0.3000 0.8660
DNSARI(1) 0.0035 0.6846 0.4208 0.6796 -0.2859 -0.1807 0.8873
DNSVAR(1) -0.5787 0.7496 0.6390 0.9426 -0.0807 -0.1470 0.7832
AR(1) -0.2691 0.6770 0.3930 0.7239 -0.3037 -0.2139 0.8702
VAR(1) -0.7456 0.7574 0.7580 1.0588 -0.0710 -0.1370 0.7137
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

6

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

RW -0.4788 1.0866 0.5924 1.1797 -0.1664 -0.1906 0.6162
PCA -0.5011 1.0494 0.6585 1.1556 -0.1813 -0.2324 0.6317
DNSAR(1) -0.6672 1.0451 0.8120 1.2331 -0.1388 -0.3366 0.5807
DNSARI(1)* -0.1142 1.1085 0.6766 1.1059 -0.1797 -0.1833 0.6627
DNSVAR(1) -1.2310 1.1345 1.2310 1.6681 0.0562 -0.1263 0.2326
AR(1) -0.5722 1.0562 0.6669 1.1941 -0.1674 -0.2238 0.6006
VAR(1) -1.4337 1.1349 1.4337 1.8231 0.1542 -0.0984 0.0383
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1
2

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

RW -1.0421 1.4510 1.0657 1.7765 -0.0961 -0.2169 -0.3063
PCA -1.1520 1.2495 1.1520 1.6917 -0.1941 -0.2004 -0.1847
DNSAR(1) -1.4090 1.2525 1.4175 1.8781 -0.3118 -0.1799 -0.4601
49

DNSARI(1)* -0.4008 1.4802 1.0516 1.5214 -0.0264 -0.2472 0.0419
DNSVAR(1) -2.4718 1.3514 2.4718 2.8116 0.0818 -0.3414 -2.2722
AR(1) -1.2165 1.3532 1.2165 1.8111 -0.1773 -0.1954 -0.3816
VAR(1) -2.6628 1.5035 2.6628 3.0516 0.0565 -0.2526 -3.0650
3

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW* -0.0655 0.2509 0.1915 0.2576 0.3769 0.2578 0.9779
PCA -0.1369 0.2613 0.2330 0.2933 0.4347 0.2514 0.9714
DNSAR(1) -0.1935 0.2617 0.2715 0.3240 0.4699 0.2052 0.9651
DNSARI(1) -0.0853 0.2503 0.2050 0.2627 0.3910 0.1978 0.9771
DNSVAR(1) -0.2808 0.2622 0.3129 0.3829 0.4601 0.2577 0.9512
AR(1) -0.0753 0.2518 0.1931 0.2611 0.3817 0.2576 0.9770
VAR(1) -0.2626 0.2824 0.3036 0.3842 0.5249 0.3255 0.9487
3

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.2086 0.5619 0.4552 0.5955 -0.5291 -0.0295 0.8758
PCA -0.3061 0.5605 0.4999 0.6350 -0.5384 -0.0460 0.8588
DNSAR(1) -0.4487 0.5549 0.5814 0.7104 -0.4889 -0.1307 0.8233
DNSARI(1)* -0.1472 0.5609 0.4463 0.5759 -0.5287 -0.0433 0.8839
DNSVAR(1) -0.7058 0.5744 0.7548 0.9074 -0.4270 0.0155 0.7117
AR(1) -0.2382 0.5614 0.4666 0.6060 -0.5207 -0.0357 0.8694
VAR(1) -0.7576 0.6163 0.7928 0.9737 -0.3141 -0.0049 0.6524
3

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

6

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.4571 0.8219 0.6714 0.9349 -0.5654 -0.0187 0.6547
50

PCA -0.5914 0.7965 0.7304 0.9871 -0.5696 -0.0370 0.6150
DNSAR(1) -0.8347 0.7819 0.9182 1.1396 -0.4587 -0.1769 0.4869
DNSARI(1)* -0.2761 0.8343 0.6346 0.8727 -0.5636 -0.0193 0.6991
DNSVAR(1) -1.3354 0.8049 1.3354 1.5560 -0.4007 0.0586 0.0434
AR(1) -0.5170 0.8115 0.6892 0.9569 -0.5557 -0.0232 0.6324
VAR(1) -1.4467 0.8298 1.4467 1.6646 -0.2315 0.0666 -0.1487
3

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1
2

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.9758 0.7696 0.9786 1.2387 -0.0964 -0.3327 0.1456
PCA -1.1709 0.6983 1.1709 1.3602 -0.3213 -0.2391 -0.0303
DNSAR(1) -1.5294 0.7441 1.5294 1.6981 -0.4795 -0.0993 -0.6056
DNSARI(1)* -0.5570 0.8209 0.7139 0.9862 -0.1247 -0.3143 0.4584
DNSVAR(1) -2.4804 0.7339 2.4804 2.5849 -0.0070 -0.3967 -2.7207
AR(1) -1.0962 0.7478 1.0962 1.3234 -0.1590 -0.3174 0.0077
VAR(1) -2.6193 0.8505 2.6193 2.7517 -0.0042 -0.2603 -3.4463
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.0575 0.2416 0.1945 0.2467 0.2241 0.2222 0.9724
PCA -0.0885 0.2473 0.2061 0.2610 0.2332 0.2093 0.9691
DNSAR(1) -0.1610 0.2514 0.2448 0.2970 0.2805 0.1944 0.9600
DNSARI(1)* -0.0568 0.2405 0.1937 0.2454 0.2009 0.1869 0.9727
DNSVAR(1) -0.2400 0.2480 0.2755 0.3439 0.2580 0.1955 0.9464
AR(1) -0.0627 0.2421 0.1956 0.2484 0.2268 0.2220 0.9716
51

VAR(1) -0.2400 0.2639 0.2818 0.3553 0.3436 0.2458 0.9402
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.1837 0.4964 0.4414 0.5259 -0.5248 0.0266 0.8697
PCA -0.2327 0.4974 0.4572 0.5458 -0.5212 0.0173 0.8597
DNSAR(1) -0.4008 0.5005 0.5344 0.6383 -0.4245 -0.0542 0.8081
DNSARI(1)* -0.1121 0.5010 0.4273 0.5097 -0.5063 0.0304 0.8776
DNSVAR(1) -0.6338 0.5003 0.6876 0.8052 -0.4521 0.0885 0.6946
AR(1) -0.1996 0.4968 0.4467 0.5320 -0.5207 0.0256 0.8647
VAR(1) -0.6918 0.5327 0.7317 0.8707 -0.3864 0.0544 0.6261
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

6

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.4046 0.7087 0.6278 0.8113 -0.6358 0.0486 0.6602
PCA -0.4776 0.7023 0.6527 0.8448 -0.6190 0.0292 0.6316
DNSAR(1) -0.7589 0.7028 0.8465 1.0307 -0.4115 -0.0964 0.4517
DNSARI(1)* -0.2297 0.7262 0.6074 0.7563 -0.6398 0.0597 0.7048
DNSVAR(1) -1.2136 0.6828 1.2231 1.3899 -0.5537 0.1336 0.0029
AR(1) -0.4381 0.7045 0.6334 0.8249 -0.6318 0.0519 0.6432
VAR(1) -1.3192 0.7070 1.3263 1.4942 -0.4152 0.1172 -0.2090
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1
2

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

RW -0.8661 0.5967 0.8899 1.0489 -0.2491 -0.3482 0.2575
PCA -0.9729 0.5822 0.9824 1.1313 -0.3638 -0.2540 0.1363
DNSAR(1) -1.3861 0.6772 1.3861 1.5401 -0.3722 -0.0495 -0.6007
DNSARI(1)* -0.4858 0.6304 0.6254 0.7916 -0.2391 -0.3429 0.5771
52

DNSVAR(1) -2.2550 0.5274 2.2550 2.3148 -0.1716 -0.4062 -2.6161
AR(1) -0.9367 0.5880 0.9471 1.1033 -0.2914 -0.3241 0.1641
VAR(1) -2.3796 0.6363 2.3796 2.4618 -0.1625 -0.2332 -3.3130
1
8

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
2
,

b
=
2
4
)

RW -0.0211 0.2350 0.1819 0.2343 -0.1321 0.1170 0.8867
PCA -0.0776 0.2501 0.2045 0.2601 -0.0877 0.0689 0.8604
DNSAR(1) -0.1320 0.2509 0.2167 0.2819 -0.0417 0.0947 0.8360
DNSARI(1) -0.0727 0.2440 0.1934 0.2529 -0.0340 0.0749 0.8680
DNSVAR(1) -0.1892 0.2346 0.2360 0.3001 -0.1369 0.0464 0.8142
AR(1)* -0.0178 0.2352 0.1821 0.2342 -0.1291 0.1184 0.8852
VAR(1) -0.1464 0.2316 0.2110 0.2726 -0.1271 0.0642 0.8397
1
8

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t


(
a
=
1
2
,

b
=
2
4
)

RW -0.0693 0.3567 0.2961 0.3608 -0.2743 -0.2189 0.7377
PCA -0.1065 0.3688 0.3122 0.3813 -0.2807 -0.1739 0.7071
DNSAR(1) -0.2393 0.3898 0.3419 0.4550 -0.1117 -0.2072 0.5829
DNSARI(1) -0.0759 0.3713 0.3061 0.3763 -0.2197 -0.2016 0.7146
DNSVAR(1) -0.4092 0.3276 0.4294 0.5227 -0.3424 -0.1812 0.4494
AR(1)* -0.0594 0.3581 0.2958 0.3604 -0.2638 -0.2164 0.7343
VAR(1) -0.4180 0.3297 0.4407 0.5309 -0.3565 -0.1259 0.4054
1
8

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

6

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
2
,

b
=
2
4
)

RW -0.1643 0.4762 0.3648 0.5003 -0.3655 -0.1921 0.5052
PCA -0.1779 0.4962 0.3851 0.5235 -0.4031 -0.1452 0.4582
53

DNSAR(1) -0.4019 0.5346 0.5114 0.6655 -0.0366 -0.1977 0.1245
DNSARI(1) -0.1050 0.5002 0.3841 0.5073 -0.3041 -0.1750 0.4912
DNSVAR(1) -0.7370 0.4118 0.7454 0.8427 -0.5294 -0.1373 -0.4038
AR(1)* -0.1444 0.4794 0.3655 0.4971 -0.3404 -0.1872 0.5037
VAR(1) -0.7916 0.4229 0.7985 0.8960 -0.5533 -0.1312 -0.6650
1
8

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1
2

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
2
,

b
=
2
4
)

RW -0.3519 0.5376 0.4379 0.6387 -0.0876 -0.0601 0.2090
PCA -0.3289 0.5384 0.4355 0.6270 -0.0826 -0.1612 0.2376
DNSAR(1) -0.6564 0.6815 0.7093 0.9420 -0.0111 -0.0142 -0.7208
DNSARI(1)* -0.1586 0.5803 0.4511 0.5968 -0.0691 -0.0752 0.3094
DNSVAR(1) -1.3089 0.3573 1.3089 1.3560 -0.2333 -0.1665 -2.5658
AR(1) -0.3104 0.5510 0.4368 0.6284 -0.0619 -0.0594 0.2209
VAR(1) -1.3917 0.3860 1.3917 1.4434 -0.2387 -0.1438 -3.2604
Table 2.11: The forecasted result comparison of seven methods. 3 methods base on DNS
model with dynamic of factor component modeled by AR(1), VAR(1), ARI(1,1). Principal
Analysis, Random Walk and two direct method AR(1), VAR(1) forecast directly the yield
data.(Starred methods as ones with minimum RMSE in its group)
We will estimate and forecast recursively, using data from Jan-1990 to the time that the
forecast is made, beginning in Feb-2004 and extending through the end of database.
The forecasted error can be defined as:
/

t h t h t
y E y
+ +
=
54

The forecast will carry on 16 cases of 4 maturities (1Y, 3Y, 5Y, 18Y) and 4 forecast
period (1, 3, 6 and 12 months)
Table 2.11 shows the statistical description of residual from seven methods. If we take
RMSE as a benchmark, DNS-ARI(1) is the best model. Among the DNS group
method, DNSVAR is the lowest performance one. This can be seen from the student
test of error mean (zero mean hypotheses). P-values of the test on every case in this
method are almost zero. However, even P-value of DNARI model is high; we should
Nelson Siegel as a bias model. This can be an inherent disadvantage of model itself:
the accuracy trade-off between two ends of yield curve. Small values of t correspond
rapid decay in the regressors and therefore will be able to fit curvature at low maturities
well, while being unable to fit the excessive curvature over longer maturity ranges and
vice versa. However, as mentioned previously, we would not expect the high fitness
from a parsimonious model.
RW 1Y 3Y 5Y 18Y
1 month 0.0317 0.0324 0.0503 0.4554
3 months 0.0095 0.0032 0.0033 0.1137
6 months 0.0007 0.0000 0.0000 0.0071
12 months 0.0000 0.0000 0.0000 0.0000
Table 2.12 P-value of test on mean error of RW forecast.
0
1
0
0
E
E
H :
H :
=
=

PCA 1Y 3Y 5Y 18Y
1 month 0.4078 0.0000 0.0038 0.0115
3 months 0.0167 0.0000 0.0003 0.0201
6 months 0.0003 0.0000 0.0000 0.0052
55

12 months 0.0000 0.0000 0.0000 0.0000
Table 2.13: P-value of test on mean error of PCA forecast
DNAR 1Y 3Y 5Y 18Y
1 month 0.2086 0.0010 0.0000 0.0000
3 months 0.0000 0.0000 0.0000 0.0000
6 months 0.0000 0.0000 0.0000 0.0000
12 months 0.0000 0.0000 0.0000 0.0000
Table 2.14 P-value of test on error mean of DNS AR forecast
DNARI 1Y 3Y 5Y 18Y
1 month 0.0716 0.9667 0.4093 0.0420
3 months 0.0057 0.0340 0.0097 0.0000
6 months 0.0522 0.0694 0.0132 0.0000
12 months 0.0150 0.0965 0.0954 0.0402
Table 2.15: P-value of test on error mean of DNS ARI forecast
DirectAR 1Y 3Y 5Y 18Y
1 month 0.0088 0.0147 0.0336 0.5283
3 months 0.0017 0.0008 0.0015 0.1756
6 months 0.0000 0.0000 0.0000 0.0180
12 months 0.0000 0.0000 0.0000 0.0001
Table 2.16: P-value of test on error mean of Direct AR forecast
We check the stationary characteristic of beta coefficient estimated from data. The unit
root test shows that, the first two beta coefficient test results fail to reject the null
hypothesis. They may contain unit root and their first order of difference series may be
stationary. Therefore, the DNARI(1) model performs better than any other method.
56

Result p-value Test Statistic
1
| 0 0.1466 -1.4142
2
| 0 0.0718 -1.7780
3
| 1 0.0245 -2.2405
Table 2.17 Dikey-Fuller test on estimated beta coefficient. Critical value is 1.9420
at 5%

Figure 2.15: RMSE comparison of seven methods
:Direct VAR(1); :RW ; :Direct AR(1); :DNS-ARI(1); :DNS-AR(1);
:DNS-VAR(1); :PCA
57

If RMSE has given us a clear choice of optimal method, correlated residual tells a
different story. While DNS-VAR(1) shows a good forecast result, it does not come
with a small autocorrelation of residual. We cannot say firmly any optimal method
with low RMSE and correlated residual.

Figure 2.16: Residual Autocorrelation of different methods
:Direct VAR(1); :RW ; :Direct AR(1); :DNS-ARI(1); :DNS-AR(1);
:DNS-VAR(1); :PCA

58

CHAPTER 3: RISK SENSITIVITY AND IMMUNIZATION
In previous chapter, we have modeled and forecasted the yield curve with various
methods. A comprehensive management of yield curve risk must include solving the
last two fundamental problems mentioned in chapter 1: quantifying the interest rate
sensitivities of a given fixed-income portfolio and developing defensive risk
management strategies from a longer term model of yield curve movement with the
relaxed assumption: non-parallel of yield curve shift. I will introduce the most classic
model from Robert Reitano. This model is a natural way to deal with the problem of
non-parallel shift. In later section of this chapter, more methods will be introduced.
3.1. Risk sensitivity
To measure the sensitivity of fixed income portfolio to change in interest rate, shift in
the benchmark yield curve or any latent factors that belong to a factor model like PCA
or DNS in the non-parallel shift assumption, we use duration analysis are the main
tools.
3.1.1. Reitano Partial Duration model
3.1.1.1. Directional Duration and Convexity:
Let
0 01 02 0
, ,..., ) (
m
i i i i = represents an m-point benchmark yield curve.
Let
1
( ,..., )
m
N n n = be a direction vector, 0 N = .
Price of bond after a shift t units in the direction N: ( ) ( )
o
P t P i tN = + [20][21][22][23]
Again, we want to measure the change of portfolio value to the yield curve movement.
Assumed P(t) to be twice continuously differentiable and recall Taylor expansion in
(0.2), P(t) can be approximated to first and second order in t as follows:
59

(t) (0) (0)t P P P' = + (3.1)

2
1 2 (0) (t) (0 (0) ) t / t P P P P ' + '' = + (3.2)
Let
j
P(i) denote the j-th partial derivative of P(i) and
jk
P (i) denote the corresponding
mixed second-order partial derivative. We then obtain:

0
(t) +tN (i )
j j
P n P ' =

(3.3)

0
+tN (i )
j jk k
P P n n '' =

(3.4)
Therefore:

0 0
0
j j
P
P
( n ) i ) i
N
P(
c
' = =
c

(3.5)

2
0 0 2
0
j k jk
( ) i )
N
P
P n n P (i =
c
'' =
c

(3.6)
Let

N
P
D (i) / P(i)
N
c
=
c
(3.7)

2
2 N
C (i) / P(i)
N
c
=
c
(3.8)
Combine (3.5), (3.6) and (3.1), (3.2) and replace with (3.7), (3.8)

0 0 0
1
N
iN) / P(i ) D P(i ) (i + A ~ (3.9)

2
0 0 0 0
1 2 1
N N
iN) / P(i ) D (i )( P(i ) / C i (i ) + + A ~ A . (3.10)
60

We call
N N
D ,C the directional duration and directional convexity function in the
direction of N. If =(1,...,1) N , the parallel shift direction vector, D
N
(i
0
) and
0
) (i
N
C can
be calculated like parallel shift approach.
Formulas (3.9) and (3.10) are consistent even though there are infinitely many ways to
specify the direction vector N, for example, given N, let N' = 1/2N. The corresponding
shift magnitudes satisfy: 2 i i A ' = A then 1/ 2 = '
N N
D D and 1/ 4 ' =
N N
C C . One can
normalize the model by requiring the direction vector N to satisfy |N|=1. The
magnitude variable, Ai , is then uniquely defined as the length of the shift vector N i A .
3.1.1.2. Partial Duration and Convexity
Consider first and second order of Taylor expansion in m-dimensional versions:

0 0 0
j
j i
i) P(i ) P(i (i P ) + A ~ + A

(3.11)

0 0 0 0
1 2
j j jk j k
i) P(i ) P(i ) i P(i / P i ) i (i + A ~ + A A A +

(3.12)
These approximations naturally motivate the following definitions:
The j-th partial duration function, denoted
j
D(i) , is defined for 0 P( i) = as follows:
1
j j
(i) P(i) / P(i), j,k , .,m D .. = =
The jk partial convexity function, denoted
1
jk jk
(i) / P(i), j, C ( k ,. i) P ..,m = =
Given the above definition, the total duration vector, denoted D(i), and the total
convexity matrix, denoted C(i), are defined as follows:
61


1 m
D(i) (D(i),...,D (i)) = (3.13)

11 1
1
m
m mm
C ( i) C ( i)
C( i)
C ( i) C ( i)
| |
|
=
|
|
\ .
(3.14)
Then

0 0 0
1 i) / P(i ) P(i D(i ) i ~ + A A (3.15)

0 0 0 0
1 1 2 i) / P(i ) D(i P(i ) i / i i i ) C( + A ~ A + A A (3.16)
We use as dot product or inner product.
3.1.2. Example
Assume a simple portfolio of three fixed cash flows:
Year Cash flow Spot rate
0 -75
1 20 0.105
2 15 0.1
3 25 0.1
4 30 0.09
5 15 0.085
Then we can calculate the price of portfolio at the spot rate vector:. At any spot vector
1 5
( ) i i ,...,i =
(1+y )
i
i i
i
CF
P( i) =


The partial derivatives:
62

2
1
1
3
2 2
4
3 3
5
4 4
6
5
5
20 1
30 1
75 1
120 1
75 1
/ ( y )
P
/ ( y ) P
P / ( y )
P / ( y )
P
/ ( y )
(
( +
(
(
(
(
+
(
(
(
(
= +
(
(
(
(
+
(
(
(
(
+
( (


and
11 22 33 3 4 5
1 2 3
44 55 6 7
4 5
40 90 300
1 1 1
600 450
1 1
(y ) (y ) (y )
(y ) (y )
P ,P ,P ,
P ,P
= = =
+ + +
= =
+ +

At i
0
1
2
3
4
5
2 974
4 0925
9 3011
141609
8 3469
D .
D .
D .
D .
D .
( (
( (
( (
( (
( (
=
( (
( (
( (
( (
( (


11 22 33
44 55
5 3829 111613 33 822
64 9582 461579
C . ,C . ,C . ,
C . ,C .
= = =
= =

0 (i j)
ij
C = = .
Then, from (3.15):
0 0
1 ) ( )( ( ) i P i D P i i + A ~ A
Now for a shifted vector 0 0005 0 001 0 0002 0 001 0 000375 ( ) i . , . , . , . , . A = , we have the
actual new price will be 5.371578636 and the approximate: 5.371344096621137 the
error is -2.3454e-04. If we use (3.16):
0 0 0 0
1 1 2 i) / P(i ) D(i P(i ) i / i i i ) C( + A ~ A + A A
Then P= 5.371579018385631 the error is 3.8212e-07
63

3.2. Factor duration models
Unlike Reitano models, factor models base on latent variables. These models present
generalized duration components that correspond to the level, slope and curvature risk
factors.
Assume that yield curve is linear in some arbitrary factors, f
1
, f
2
and f
3
so that
2 1 1 2 3 3
( ) ) ( ( ) ) (
t t t t
y f f B B f B t t t t + + =
For an arbitrary change of the yield curve the price change is
1 1
( )
) ( ( [ )] ( ),
( )
i t i
I I
i
y
i i i i t i
t i
i
dP dy Ce
P
dy
y
t t
t t t
t
= =

c
=
c
=


Where ) (
i i
y t is treated as independent variables. Rearranging terms, we can express
the percentage change in bond price as a function of changes in the following factors:
3 3
1 1 1 1
1
( )
( ) ( )
i t i
y
i i j i
I I
j i j i
it i i j i it
dP
CF B w B e d
P
f
P
f d

= = = =

(

= =
` `
(
)
)

t t
t t t t
Where
i
w is the weight associated with
i
CF . Since we have decomposed the bond
price changes into risk factor changes, the duration component associated with each
risk factor is, for j=1,2,3

1
( )
I
j i i j i
i
B D wt t
=
=

(3.17)
We will consider two factor based duration models: PCA and Nelson Siegel.
3.2.1. PCA duration [1][9]
Barber and Copper (1996) introduced PCA duration used in portfolio immunization.
64

Recall that the variations of interest rates for each maturity of a yield curve can be
written as a linear combination with weights l of a number (K) of independent factors f.
1 1 , , ,
... ...
k K j j j j k j K
y c f f f + + + + A = +
Let
P
k
D be the duration of portfolio surplus (net present value) at factor-k.

1
1,. ) .., (
k i k i i
N
P
i
N w k K t l t D
=
(
= =
(

(3.18)
3.2.2. NS duration based approach
Base on the NS model, the vector duration is [10]:
1
1 i i
I
i
D wt
=
=

1
2
1
1/
i
i
I
i
e
D w

1
3
1
i
i
i i
I
i
e
D w e

=
| |
|
=
|
|
\ .

t
t

The vector duration measure has the following properties:
D
1
, D
2
and D
3
increase with maturity t
D
1
, D
2
and D
3
decrease with coupon rate; and
D
1
, D
2
and D
3
decrease with the yield to maturity
These three durations are equivalent to three risk factors: level, slope and curvature,
besides, we can consider another risk factor: speed of convergence.
65

2
3
4 1 2 2 2 3
1
1 ( ) ( )
I
i
i
r
t t
D w exp
=

(
| | | | |

= | + | | + | + +
( ` | |

( \ . \ .

)

3.3. Immunization approaches
This section will introduce the matching and immunization strategies, which are for
static and deterministic purposes. That is, all the future variables for prot and loss
accounts (e.g. liability cash ows, payments of bonds portfolio and the future interest
rate) are already known today. There are several dierent immunization approaches.
3.3.1. Cash flow matching
The simplest way to cope with yield curve risk is to match positive with negative cash
flows as much as possible. This approach of cash flow matching is not only
theoretically straightforward, but also very effective in minimizing yield curve risk.
Unfortunately, the dates and the amounts of future cashflows are often subject to
constraints in practice, so that implementing an accurate cashflow matching might not
be possible.
3.3.2. Traditional Duration Matching
When cashflow matching is not possible, socalled traditional duration matching
techniques are employed to manage yield curve risks. These techniques have the goal
of making the sensitivity of assets and liabilities to yield curve changes as much as
possible similar to each other. The key idea behind these techniques is that if assets and
liabilities react in a similar way to a change in the yield curve, the overall interest
income will not be largely affected by this change. Macculay and Modified Duration
are the basic tools in this technique.

66







Figure 3.1:Bond Price Change by Interest Rate Movements
3.3.3. Duration Vector Model
Since the traditional duration matching can only be applied properly based on the
assumption of a parallel and infinitesimal shift in a flat yield, this model has in reality
very limited applicability. One of approaches to overcome this is Duration Vector
Model. It is called vector model because it needs to calculate a vector of higher order
duration measures. There are two forms of Duration Vector Model, traditional and
generalized model. The generalized duration vector model is actually an expansion of
the traditional duration vector model, which seems to be more eective in protecting
against immunization risk than the traditional duration vector model, without
increasing the vector length.
To derive the duration vector model, we also start with describing changes in bond
values (P). Let the continuously compounded term structure of instantaneous forward
rates be given by f(t ) . Then an instantaneous shift in the forward rates from f(t ) to
f (t ) ' can be obtained as f '(t ) f(t ) f(t ) = + A . The instantaneous percentage change
in the current value of the bond is given as:
Fixed income portfolio
Price/
Value
P
1
P
2
P
3
Planned liability
Planned liability

67

2
2
2
1
1
0
3
0
1
2
3
0
1
2
1
3
3
1
2
0
0
0 0
0
[
!
]
t
t
M
M
M
M
t
P
f( )
( f(t ))
f( ))
t
( f(t )) ( f(t ))
f( ) f( ))
(t ) t
( f(t )
D
P
D (
D (
D ... (
)
f( ))
t
=
=

=
A
A
c A
A
c
c A c
A
=
(
| |

( |
\ .

(
| |

( |
(
\ .

(
| |
+ A
c c
c A
+ +
( |
(
\ .

A
c

where
m
i
m i i
CF
D t ,
P
=

for m = 1, 2,, M and

In this general case:
The first element of the duration vector is the traditional duration measure given as
the weighted-average time to maturity, and the measure given as the weighted average
time to maturity, and the first shift vector element captures the change in the level of
the forward rate curve for the instantaneous term, given by 0 f( ) A
The second shift vector element captures the difference between the square of this
change and the slope of the change in the forward rate curve (given by
f(t )
t
cA
c
at t =
0);
The third shift vector element captures the effect of the third power of the change in
the level of the forward rate curve, the interaction between the change in the level and
68

the slope of the change in the forward rate curve and the curvature of the change in the
forward rate curve, and the curvature of the change in the forward rate curve (given by
2
2
( f(t ))
t
c A
c
at t =0);
Generally, the first three to five duration vector measures are sufficient to capture all of
the interest rate risk inherent in bond sufficient to capture all of the interest rate risk
inherent in bond portfolios.
3.3.4. Key rate immunization model
This method based on key rate duration model, which was introduced by Ho (1992).
The basic idea behind the key rate duration model is that any smooth (zero coupon)
yield curve change can be modeled as a linear combination of a much smaller set of
yield changes. These zero rates are also called key rates. The key rate duration model
describes the shifts in the term structure as a discrete vector representing the changes in
the key zero-coupon rates of various maturities. Interest rate changes at other maturity
can be derived from these values via linear interpolation. Key rate durations are then
defined as the sensitivity of the portfolio (liability) value to key rates at different points
along the term structure.
( )
i
i i
KRD
P
y
P
t
A
A =
Where
i
KDR is the i-th key rate duration, in a continuous time we get
1
.
( )
i
i
KDR
P
P
y t
c
=
c

Then we have the change in price:
69

( )
i i
P
y KRD t
P
A
A =

where the sum is across all key rate maturities.
Therefore, we can consider this model as a directional duration model.
If we denoted the key rates by
i
t where i=1 n; and [ ( )] s t i as the shift at each key rate.
Then the yield curve shift along the maturity range ( ) s t can be approximated by linear
interpolation of the shifts of each key rate.
In this model, the yield curve components in
0
i are spot rates, often on a monthly
basis. A collection of "pyramid" direction vectors, N
j
, are then defined, such as:
N
j
= (0,,0, 1/2, 1, 2/3, 1/3, 0, 0 )
The actual spot rate corresponding to the component 1 in N
j
is the key rate and the
various key rate durations are equivalent to the directional durations D
N
(i
0
).

Figure 3.2: Yield curve shift at a key rate
.



yield
term
70


Figure 3.3: Yield curve shift in key rates
The linear interpolation
Suppose that we choose n key rates. Let ( , )
i
s t t be the contribution of i-th basic key rate
shift with magnitude ( )
i
y t A to the total level of shift ( ) y t A at the zero coupon rate t,
then:
1 1
1
1 1
1 1
( )
( ) ( ( ) )
(
,
)
k k
i k k k k
k
n
k k
n
k
y t t t
t t t
y t y t t t t
t
t
s t
t t
y t
t
t
t
t
+
+ +
+ +
A <

A + A < <

A >

Therefore, the change in a zero coupon ( ) y t A can be written as:
t(m) t(i) t(1) t(2) t(i+1)
71

1
( )= ( )
m
i
i
y t s t,t
=
A

In other words, key rate duration measures the effect of a change in the yield curve that
is localized at a particular maturity, and restricted to the immediate vicinity of that
maturity, usually by having the change drop linearly to zero at neighboring points.
3.3.5. Factor duration based immunization
This method uses factor duration models introduced above: PCA and DN factor model.
With a few factors, these models are fast in optimization but still give a good
performance.
3.4. Portfolio Optimization in immunization
The immunization problems can be:
- To immunize a portfolio for a planning horizon of H years, the duration model
requires setting the portfolio duration match hypothetical default-free zero
coupon bond maturing at H.
- To fulfill a liability cash flow in H years, financial institution forms a portfolio
from a number of risk free assets. Again, the liability is immunized with the
same condition as above.
The factor models hedge against the shape changes in the height, slope and curvature,
while the key rate durations hedge against the changes in a nite number of key rates
that proxy for the shape changes in the entire term structure. Our immunization
strategies based on above duration models provide an infinite number of immunizing
solutions because the number of bonds included in the portfolios usually exceeds the
number of constraints. According to the management requirement, we can optimize the
72

solution to meet the desired target: maximize return, surplus, minimize variance. In this
thesis, we simply require a maximum diversification. In particular:
1
1
2
1 1
1
Min
s.t
n
i
n
i
i
portf
i
t arg et
k k
w ,
w ,
D D
=
=

=
=

where
target
D denes the target duration vector (in k dimensions, each one related to
each risk factor) and
portf
D the portfolio duration vector, which is calculated from
individual bond duration vectors as
portf bonds bonds
D D W , =
Where W is the vector of bond weights and n is the number of bonds included in the
portfolio. The above expression clearly shows that fewer duration constraints result in a
lesser degree of diversification. Furthermore, as the number of duration constraints
grows we can expect higher transaction costs due to heavier reallocations. Thus, there
is a trade-off between more effective immunization and the above disadvantages as
successive duration constraints are imposed.
We generalize the immunization strategy based on every approach of duration analysis
above. From now on, terms like PCA Immunization, for example, will represent the
immunization strategies based on PCA duration analysis.
+ Key rate Immunization
Given the key rate
0 01 02 0
, ,..., ) (
m
i i i i = , then the target duration will be:
73

0
(i )
t arget H
D D =
+ PCA Immunization
For a three component PCA we have:
1
2
3
(H)H
(H)H
(H)H
t arg et
u
D u
u
| |
|
|
=
|
|
\ .

+ NS Immunization
Taking the four risk factors of the NS model (level, slope, curvature and speech of
convergence)
2
3
1 2 2 3 2
1
1 1
1 ( )- ( )
t arg et
H
H
exp
D
H H
exp
H
H H
exp
| |
|
|
(
| |
|
( |

|
\ .

|
=
(
| | | |
|
+
( | |
|
|
\ . \ .

|
|
(
| | | | |
|
| + | | + | + +
(
| |
|

( \ . \ .

\ .

3.5. An application to England Government Bond Data
3.5.1. Portfolio Design
In this application, we assume that a financial institution has to pay a liability cash flow
of GBP 100 (million) in 10 years. Assume that the benchmark term structure will based
on monthly England Government Bond Yield in 31/12/2006. To immunize this liability
74

stream, we will test three different kind of fixed income portfolio: Barbell, Bullet and
Laddering
Maturity Yield Maturity Yield
12 5.18% 120 4.63%
24 5.10% 132 4.58%
36 5.04% 144 4.55%
48 4.97% 156 4.51%
60 4.91% 168 4.47%
72 4.85% 180 4.44%
84 4.78% 192 4.40%
96 4.73% 204 4.37%
108 4.67% 216 4.33%
Table 3.1: Yield curve of England Government Bond in 31/12/2006
Barbell strategy is formed by investing in Long and Short duration bonds, but not by
investing in the intermediate duration bonds. This strategy is useful when interest rates
are rising; as the short term maturities are rolled over they receive a higher interest rate,
raising the value. The barbell strategy allows for a quick turnover of a significant
amount of the assets in the portfolio at one time.
A bullet strategy is formed by investing in intermediate duration bonds, but does not
invest in the Long and Short duration bonds. The bullet strategy is based on the
acquisition of a number of different types of securities over an extended period of time,
but with all the securities maturing around the same target date.
Laddering is an investment technique that requires investors to purchase multiple
financial products with different maturity dates. Each "rung" of the ladder is a bond of
75

a specific maturity date and the "height" of the ladder is the difference between the
shortest maturity bond and the longest maturity bond.
Table 3.2 is the detail of each type of portfolios design.
Portfolio Asset Coupon
Barbell 1Y, 2Y, 3Y, 16Y, 17Y 18Y 5% 8% 7.5% 4.75% 4.25% 4.5%
Bullet 4Y, 5Y, 6Y, 7Y, 8Y, 9Y, 10Y 12% 5% 4.5 4.75% 3.75% 3.75%
6%
Laddering 1Y, 3Y, 5Y, 7Y, 9Y, 11Y, 13Y,
15Y, 17Y
5%, 7.5%, 4.5%, 3.75%, 1.75%,
5%, 4.5%, 6%, 4.75%
Table 3.2: Portfolio designs
To select the key rate in the key rate immunization strategy, by having a glance at the
historical spot yield we can nd out that the yield change of dierent maturities which
are highly correlated with each other. So we decompose the zero interest rate curves
into m buckets, where the price changes are most highly correlated. Table 3.3 shows us
the correlation matrix of the historical yield curve changes. According to the
correlation we decompose the 20-year-yield curve into 7 buckets: [1Y], [2Y, 3Y], [4Y,
5Y, 6Y], [7Y, 8Y, 9Y], [10Y, 11Y, 12Y, 13Y], [14Y, 15Y, 16Y, 17Y], [18Y]. The
corresponding key rates are: 1-year, 2-year, 5-year, 8-year, 15-year, 18-year spot rates.
Now we can model the sensitivity of assets/liabilities with respect to these

76

.


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T
a
b
l
e

3
.
3
:

C
o
r
r
e
l
a
t
i
o
n

M
a
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r
i
x

o
f

S
p
o
t

R
a
t
e
s

S
h
i
f
t
s

77

3.5.2. Result of portfolio optimization
Table 3.4, 3.5, 3.6 show results achieved by using quadratic optimization from matlab,
In this application, we assume the allowance of shortsales and borrowing from market.
The weights here are not necessary to conform to traditional way bonds in these
portfolios are allocated.
Weight PCA DN KR
w1 -0.9471 -0.7554 -1.0639
w2 0.7052 0.9153 1.318
w3 0.4165 -0.0582 -0.0482
w4 0.0011 -0.4106 -0.2711
w5 0.1895 0.6082 0.3722
w6 0.3897 1.1601 0.6656
w7 0.2452 -0.4593 0.0273
Table 3.4: Portfolio allocation for Bullet Strategy
Weight PCA DN KR
w1 0.0317 0.0407 -0.0341
w2 -0.2845 -0.2942 -0.1077
w3 -0.0676 -0.0963 -0.2446
w4 0.2338 0.2328 0.2873
w5 0.4538 0.503 0.3183
w6 0.3562 0.3934 0.5753
w7 0.2529 0.238 0.4079
w8 0.0967 0.0423 -0.2025
w9 -0.0729 -0.0597 0
Table 3.5: Portfolio allocation for Laddering Strategy
78

Weight PCA DN KR
w1 0.073 -0.1092 -0.0226
w2 -0.2366 0.2623 0.2935
w3 -0.0848 -0.4347 -0.3579
w4 0.7819 0.6808 -4.2662
w5 0.4383 0.8888 10.1556
w6 0.0282 -0.288 -4.8024
Table 3.6: Portfolio allocation for Barbell Strategy
To compare the performance of these immunization strategy combinations, we will
estimate the surplus with an immediate interest shock right after purchasing for 8 case:
parallel shift, an upward sloping shift, a downward sloping and finally, a yield curve
swing with small, medium and an extreme change.
There are total 15 subcases. In each case, the benchmark yield curve will be modified
by below change vector; each vector has 18 elements and represents the change in each
maturity.
M
a
t
u
r
i
t
y

Small change (bp) Medium change (bp) Extreme change (bp)
1
i A

2
i A

3
i A

4
i A

5
i A

1
i A

2
i A

3
i A

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i A

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i A

1
i A

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5
i A

1 5 -5 5 -5 5 10 -10 5 -5 5 100 -100 5 -5 5
2 5 -5 5 -5 6 10 -10 7 -7 13 100 -100 13 -13 58
3 5 -5 6 -6 8 10 -10 8 -8 23 100 -100 24 -24 158
4 5 -5 6 -6 9 10 -10 10 -10 35 100 -100 37 -37 305
5 5 -5 6 -6 10 10 -10 12 -12 50 100 -100 53 -53 500
6 5 -5 6 -6 10 10 -10 14 -14 45 100 -100 72 -72 450
7 5 -5 7 -7 9 10 -10 16 -16 40 100 -100 93 -93 388
8 5 -5 7 -7 9 10 -10 19 -19 36 100 -100 117 -117 330
9 5 -5 7 -7 8 10 -10 21 -21 32 100 -100 143 -143 276
10 5 -5 8 -8 8 10 -10 24 -24 28 100 -100 172 -172 227
11 5 -5 8 -8 8 10 -10 27 -27 24 100 -100 204 -204 183
12 5 -5 8 -8 7 10 -10 30 -30 21 100 -100 239 -239 144
79

13 5 -5 9 -9 7 10 -10 33 -33 18 100 -100 276 -276 109
14 5 -5 9 -9 7 10 -10 36 -36 15 100 -100 315 -315 79
15 5 -5 9 -9 6 10 -10 39 -39 12 100 -100 357 -357 53
16 5 -5 9 -9 6 10 -10 43 -43 9 100 -100 402 -402 33
17 5 -5 10 -10 5 10 -10 46 -46 7 100 -100 450 -450 16
18 5 -5 10 -10 5 10 -10 50 -50 5 100 -100 500 -500 5
Table 3.7: Change in benchmark yield curve
Small change case will modify each yield curve within a narrow band [-0.001, 0.001],
while bands in other cases are [-0.005, 0.005] and [-0.05, 0.05]. From the result of
three cases in table 3.8, 3.9, 3.10, we can initially conclude that:
- In consideration of number of positive results, immunization using Nelson
Siegel duration gives the best performance and even the best in first two cases.
In the last case, the first position belongs to PCA duration based method.
In other extreme, PCA gives so many negative results of all three methods.
Bullet method also performs better than others in combination with
immunization.
- However, if we consider the hedging ratio:
0
Surplus
HR=
P
A

Then, the best method now is up to which case of change is. Nelson Siegel will
be the best method in first three and even four sub cases of yield change. In the
case of curvature change, the method becomes less efficient, especially in
extreme movement of yield.
Other method however performs better in this subcase, even in extreme case.
Key rate duration based immunization is the best in curvature shift.
80

Case #
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1 0.992 0.451 2.886 0.000 0.000 0.000 -1.839 0.502 0.166
2 -0.880 -0.352 -2.752 0.000 0.000 0.000 1.855 -0.509 -0.167
3 -12.003 -10.863 -12.691 0.000 0.000 0.000 -4.867 1.469 0.303
4 12.760 11.658 13.578 0.000 0.000 -0.001 2.491 -1.099 -0.377
5 -38.961 29.184 -45.191 -42.496 7.001 -76.743 -0.468 0.169 1.191
Table 3.8: Surplus of each strategy in small change case
Case #
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1
2 1 6 0 0 0 -4 1 0
2
-2 -1 -5 0 0 0 4 -1 0
3
-146 -139 -178 0 0 -2 220 -31 0
4
169 167 197 0 0 -3 -343 50 -11
5
-521 227 -694 -550 79 -917 398 -81 8
Table 3.9: Surplus of each strategy in medium change case
Case #
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1 39 26 81 0 0 0 -27 8 3
2 6 14 -27 0 0 0 33 -10 -4
3 -1148 -892 -1659 -14 -22 -122 -78 33 -393
4 3236 3751 2412 -68 -100 -1252 -14050 2069 -1554
5 -6281 2448 -8625 -6365 1033 -10685 6111 -1025 -489
Table 3.10: Surplus of each strategy in extreme change case
81

Case #
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1
0.16 0.07 4.58 0.00 0.00 0.00 -2.92 0.80 0.26
2
-0.14 -0.06 -4.37 0.00 0.00 0.00 2.95 -0.81 -0.27
3
-1.91 -1.73 -20.16 0.00 0.00 0.00 -7.73 2.33 0.48
4
2.03 1.85 21.57 0.00 0.00 0.00 3.96 -1.74 -0.60
5
-6.19 4.64 -71.77 -67.49 11.12 -121.88 -0.74 0.27 1.89
Table 3.11: Surplus of each strategy in small change case (
6
10 )
Case
#
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1
0.03 0.02 0.09 0.00 0.00 0.00 -0.06 0.02 0.01
2
-0.03 -0.01 -0.09 0.00 0.00 0.00 0.06 -0.02 -0.01
3
-2.32 -2.21 -2.83 0.00 0.00 -0.03 3.49 -0.50 0.01
4
2.68 2.65 3.14 0.00 0.00 -0.04 -5.44 0.80 -0.17
5
-8.28 3.60 -11.02 -8.73 1.25 -14.57 6.33 -1.28 0.13
Table 3.12: Surplus of each strategy in medium change case (
4
10 )
Case #
Principal Component
Analysis
Nelson Siegel Key rate duration
Barbell Bullet Ladder Barbell Bullet Ladder Barbell Bullet Ladder
1
0.01 0.00 0.01 0.00 0.00 0.00 0.00 0.00 0.00
2
0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.00 0.00
3
-0.18 -0.14 -0.26 0.00 0.00 -0.02 -0.01 0.01 -0.06
4
0.51 0.60 0.38 -0.01 -0.02 -0.20 -2.23 0.33 -0.25
5
-1.00 0.39 -1.37 -1.01 0.16 -1.70 0.97 -0.16 -0.08
Table 3.13: Surplus of each strategy in extreme change case (%)
82

- Parallel shift is the case which easily to be immunized, we receive good result
all the time with any methods. Curvature shift is the most troublesome case as
most immunization results are negative.

83

CHAPTER 4: APPLICATION TO VIETNAMESE BOND MARKET
4.1. Data
The database is provided by Reuters Bond Benchmark fixing. The fixing is calculated
from the daily rates updated during 07:00 10:50 VNT (00:00 03:50 GMT) for the
day. Calculation of the fixing is done at 11:00 VNT. The data ranges from 1/8/2008 to
8/7/2013
Fixing calculation Method:
1) MID rate = (BID yield + ASK yield) / 2
2) Eliminate the 25% highest and 25% lowest MID rates of the day as follows:
- Less than 6 contributors, fixing cannot be done on that day
- Total 6 9 contributors, eliminate 2 Highest and 2 Lowest rates
- Total 10 13 contributors, eliminate 3 Highest and 3 Lowest rates
- Total 14 16 contributors, eliminate 4 Highest and 4 Lowest rates
3) Average the remaining MID rates
4.2. Yield curve modeling

84


Figure 4.1: PCA analysis of VN bond yield from 29/08/2008 to 8/7/2013
The result of PCA shows that the main component is still the level factor (71.0115%),
sloping factor is the second with 18.0086%, and curvature factor is not far from behind
with 4.3221%. This result is totally different from what we have achieved up to now.
We can see that the change in long term yield is larger than the short term in the second
factor, which is upward sloping rather than downward sloping like the case of UK
market.
We will study further by analyses the statistical descriptive of monthly data. Figure 2.1
shows the term structure surface of Vietnamese bond yield, which shows a decreasing
through years in all maturity. Besides, we can be sure that there are any specific
patterns of yield curve dominating the whole period.
85


Figure 4.2: Surface of VN bond yield
Maturity
(Months)
Mean
Standard
Deviation
Min Max 1 ( ) 6 ( ) 12 ( ) 20 ( )
12 10.24 2.31 6.00 17.10 0.80 0.00 -0.26 -0.17
24 10.49 2.08 6.65 16.92 0.79 -0.04 -0.23 -0.18
36 10.60 1.98 6.76 16.71 0.79 -0.05 -0.22 -0.18
60 10.81 1.76 7.90 16.19 0.79 -0.05 -0.22 -0.19
84 10.88 1.54 8.65 15.54 0.80 -0.04 -0.23 -0.19
120 10.93 1.43 8.93 15.26 0.79 -0.03 -0.23 -0.19
180 10.97 1.39 9.10 15.20 0.79 -0.03 -0.23 -0.19
Level 10.97 1.39 9.10 15.20 0.79 -0.03 -0.23 -0.19
Slope 0.73 1.09 -1.90 3.23 0.82 0.10 -0.35 -0.10
Curvature 0.00 0.50 -1.71 1.13 0.61 -0.37 0.00 -0.15
Table 4.1: Statistical Description of VN Bond Yield
Again, the statistical description of monthly yields shows a same characteristic as
above analysis: a decreasing level of volatility accompanied with otherwise increasing
86

mean of yield rates from short-term to long-term. However, four autocorrelations do
not monotonically decreasing, which proves a season effect in data.
On the other hand, DNS model perform better in Vietnamese Bond Yield. Initially,
from the PCA result, we will analogously find that maximize the third factor loading
at 5 year. Solve the first order derivative of third factor loading we find =33.4583 .

Figure 4.3: Fitted yield curve at 29/08/2008 using mean data and mean estimated
parameters.
87


Figure 4.4: Fitted yield curve at selected date
Figure (2.3) and (2.4) show the fitted DNS model. The model works well with 5 cases
including the upward and downward sloping yield curve.
Maturity
(Months) Mean Std.Dev Min Max MAE RMSE
1 ( ) 8 ( ) 20 ( )
12 0.002 0.031 -0.055 0.097 0.025 0.002 0.417 0.042 -0.308
24 0.008 0.062 -0.197 0.118 0.048 0.008 0.487 0.020 -0.373
36 -0.026 0.073 -0.327 0.127 0.052 0.026 0.629 0.007 -0.110
60 0.018 0.062 -0.096 0.203 0.051 0.018 0.468 0.019 -0.123
84 0.007 0.088 -0.200 0.251 0.070 0.007 0.596 -0.020 -0.059
120 -0.005 0.043 -0.128 0.068 0.032 0.005 0.578 -0.079 -0.128
180 -0.004 0.058 -0.155 0.157 0.044 0.004 0.605 0.022 -0.105
Table 4.2: Statistical description of residual
88

The estimated beta is lower than England data and also has a low RMSE. The model
residuals show a low autocorrelation, forecast results based on estimated beta are
therefore more meaningful.
4.3. Forecasting Yield curve
We also divide data into 2 parts, the first part for estimating parameters, and other part
for backtesting. Using seven methods above, we will forecast the yield for 1Y, 2Y, 5Y
and 15Y with the forecasting period: 1 month, 3 months due to the low sample data
size,
From the forecasted result, we can see that, the model only works well with 1 month
forecast, with 3 month, RMSE become higher. Direct VAR(1) is not suit with
Vietnamese Data. Dynamic Nelson Siegel is still the best method in both cases. One
important thing from Vietnamese case is that, the autocorrelation of residual is low.
Therefore the forecast result is more trustable.
89

Name Mthd Mean
Std
dev
AME RMSE ( ) a ( ) b R
2
pvalue
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

1 -0.2903 0.7141 0.4742 0.7564 -0.1826 0.1109 0.8900 0.0641
2 -0.2061 0.7533 0.5211 0.7650 0.0099 0.0436 0.8875 0.2029
3 -0.2290 0.7462 0.5203 0.7648 0.0014 0.0476 0.8875 0.1553
4 -0.1121 0.7421 0.5024 0.7344 -0.4293 0.1137 0.8963 0.4762
5 -0.5405 1.0573 0.9255 1.1668 0.3307 -0.1928 0.7382 0.0226
6 -0.2133 0.7456 0.5149 0.7598 -0.0265 0.0594 0.8837 0.1839
7 -0.7666 1.0777 0.9861 1.3033 0.1547 -0.1496 0.6218 0.0025
1

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
,

b
=
1
2
)

1 -0.9174 1.1634 1.0842 1.4597 -0.4142 -0.0184 0.5622 0.0017
2 -0.6407 1.2950 1.1200 1.4170 -0.1994 -0.1126 0.5874 0.0346
3 -0.7017 1.3069 1.1539 1.4556 -0.2198 -0.1081 0.5646 0.0231
4 -0.4521 1.2438 1.0603 1.2953 -0.3890 -0.0003 0.6552 0.1114
5 -1.0015 1.6772 1.6125 1.9189 -0.0055 -0.1489 0.2434 0.0127
6 -0.6489 1.2740 1.1017 1.4025 -0.2316 -0.1029 0.5746 0.0301
7 -0.9409 1.8242 1.7173 2.0136 0.0482 -0.1689 0.0198 0.0283
2

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

1 -0.2469 0.6014 0.4025 0.6379 -0.1264 0.1028 0.8920 0.0617
2 -0.2047 0.6211 0.4179 0.6410 -0.0084 0.0527 0.8910 0.1283
3 -0.2062 0.6278 0.4253 0.6477 -0.0051 0.0852 0.8887 0.1295
4 -0.0940 0.6603 0.4435 0.6526 -0.3433 0.0939 0.8870 0.5018
5 -0.5124 0.9158 0.8093 1.0319 0.2899 -0.1864 0.7174 0.0136
6 -0.1839 0.6329 0.4247 0.6457 0.0441 0.0525 0.8841 0.1774
7 -0.7350 0.9763 0.9260 1.2050 0.2049 -0.1697 0.5538 0.0016
2

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

1 -0.7817 1.0120 0.9393 1.2595 -0.3641 -0.0245 0.5529 0.0021
2 -0.5879 1.0901 0.9311 1.2155 -0.2237 -0.1098 0.5836 0.0226
3 -0.6153 1.1107 0.9590 1.2464 -0.2709 -0.1022 0.5621 0.0195
4 -0.3643 1.0983 0.9371 1.1321 -0.3797 0.0047 0.6388 0.1442
5 -0.9077 1.4502 1.3966 1.6814 -0.0130 -0.1574 0.2033 0.0095
6 -0.5560 1.1148 0.9453 1.2218 -0.2054 -0.1178 0.5571 0.0333
7 -0.8457 1.6307 1.5285 1.8021 0.0503 -0.1835 -0.0768 0.0276
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

1 -0.2015 0.4978 0.3289 0.5269 -0.1698 0.0589 0.8862 0.0652
2 -0.1173 0.5076 0.3250 0.5101 0.0079 0.0310 0.8933 0.2795
3 -0.0849 0.5069 0.3261 0.5030 -0.0331 0.0657 0.8963 0.4306
4 0.0195 0.5362 0.3797 0.5248 -0.3012 0.0867 0.8871 0.8629
5 -0.3821 0.7930 0.7039 0.8646 0.3343 -0.1922 0.6935 0.0306
6 -0.1557 0.5192 0.3496 0.5311 -0.0155 0.0269 0.8788 0.1644
90

Table 4.3: Result of forecasted yield curve from 7 methods. Starred method means its
RMSE is lowest one in that case. (RW, PCA, DNS-AR(1), DNS-ARI(1)*, DNS-VAR(1),
Direct AR(1), Direct VAR(1))

7 -0.6670 0.8475 0.8254 1.0639 0.1535 -0.1837 0.4628 0.0010
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
6
,

b
=
1
8
)

1 -0.6246 0.7683 0.7000 0.9759 -0.3836 -0.0330 0.5751 0.0013
2 -0.4312 0.8414 0.7143 0.9275 -0.2294 -0.1261 0.6162 0.0292
3 -0.4311 0.8570 0.7185 0.9409 -0.3146 -0.1039 0.6050 0.0320
4 -0.1822 0.8557 0.6891 0.8547 -0.3820 -0.0044 0.6741 0.3408
5 -0.7164 1.1750 1.1484 1.3521 0.0122 -0.1670 0.1843 0.0112
6 -0.4561 0.8429 0.7148 0.9406 -0.2254 -0.1335 0.5845 0.0222
7 -0.7248 1.3475 1.2874 1.5015 0.0732 -0.1885 -0.1834 0.0229
1
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

1

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
2
,

b
=
2
0
)

1 -0.1308 0.3636 0.2221 0.3789 -0.1257 -0.0170 0.8851 0.0984
2 -0.0902 0.3846 0.2640 0.3868 0.0185 -0.0774 0.8803 0.2727
3 -0.0764 0.3749 0.2181 0.3745 -0.0595 -0.0309 0.8877 0.3387
4 0.0196 0.4627 0.3450 0.4529 -0.0424 -0.0941 0.8358 0.8406
5 -0.3639 0.6684 0.5697 0.7482 0.3177 -0.0857 0.5520 0.0160
6 -0.1085 0.3741 0.2517 0.3817 0.0078 -0.0503 0.8779 0.1782
7 -0.6187 0.6910 0.7311 0.9163 0.2481 -0.1797 0.2219 0.0003
1
5

y
e
a
r

t
o

m
a
t
u
r
i
t
y

-

3

m
o
n
t
h

f
o
r
e
c
a
s
t

(
a
=
1
2
,

b
=
2
0
)

1 -0.4170 0.5477 0.4489 0.6779 -0.3352 -0.0047 0.6031 0.0023
2 -0.2903 0.5865 0.4982 0.6418 -0.1543 -0.1118 0.6443 0.0345
3 -0.3381 0.5862 0.4673 0.6646 -0.3470 -0.0324 0.6186 0.0156
4 -0.0966 0.6816 0.5272 0.6721 -0.2541 -0.0015 0.6098 0.5234
5 -0.6216 0.8385 0.8471 1.0276 0.0521 -0.1237 0.0880 0.0029
6 -0.3255 0.5909 0.5089 0.6622 -0.1855 -0.0962 0.6013 0.0202
7 -0.6253 0.9749 0.9614 1.1385 0.1154 -0.1644 -0.3170 0.0081
91

CHAPTER 5: CONCLUSIONS
This thesis tries to build a general framework of yield curve risk management, one of
the most important parts in risk management. The main focuses are risk sensitivity
measurement, modeling yield curve and hedging. I have applied factor model in
modeling and forecasting the yield curve. Their performances are highly considerable.
The dynamic Nelson Siegel has been proved to be a good forecast model. However, the
parameter selection is still intuitive and in some turbulent period, it does not fit well
with data and there is a trade-off between the fitness of short-end and long-end of the
yield curve. As an improvement, the Nelson Siegel and Svensson added another term
modeled the second hump of yield curve.
PCA analysis is a general factor analysis approach. There are two main advantages in
using this model. Firstly, due to the orthogonal characteristic between factors, they are
independent in Gaussian environment and can be used as a benchmark when we
working on other factor models. Secondly, we can reduce the dimension of model as
the importance of each factor is known from the PCA result. To improve the stable of
estimated component, we should use standardized data. The main drawback of PCA
method is that it based on the second-order statistics (i.e., exploit correlation/
covariance properties). However, interest rates, like most financial variables, show
leptokurtic behavior and the Gaussian behavior hypothesis is rejected. In this context,
using PCA factors which do not take into account the moments higher than order two,
implies assuming misspecification errors. One of the method to solve this problem is
Independent Component Analysis.
Next fundamental is hedging, and this problem goes with risk sensitivity measurement.
In this thesis, the assumption parallel shift of yield curve has been relaxed by the
introduction of Reitanos duration model. However, the choice of key rate in this
model is still objective.in exchange for the simplicity and dimension. In application to
92

portfolio immunization, it gives a good hedging ratio in case of curvature shift even in
the extreme case. However, if financial institute follows the surplus target, they should
follow immunization approach base on Nelson Siegel duration in small and medium
change and key rate duration in extreme case.
The application in Vietnamese data bears the same results as England case, and
dynamic Nelson Siegel even perform better. Under the borrowing and short-sale
constraint, the application of portfolio allocation is impossible.
In the future research, beside those improvements mentioned above, the non-arbitrage
theory and the implied optionality should be incorporated to the modeling yield curve
and immunization. These improvement hopefully will make the asset and liability
management comprehensive.

93

APPENDIX
A. MATHEMATIC BASIS
A.1. Central difference approximation
( ) ' = f x The derivative of a function f at a point x is defined by the limit
0
( ) ( )
( ) lim .
h
f x h f x
f x
h

+
' =
If h has a fixed (non-zero) value instead of approaching zero, then the right-hand side
of the above equation would be written
[ ]( )
( ) ( )
.
h
f x
f x h f x
h h
A
+
=
Hence, the forward difference divided by h approximates the derivative when h is
small. The error in this approximation can be derived from Taylor's theorem. Assuming
that f is continuously differentiable, the error is
0
[ ]( )
( ) ( ) ( ).
h
f x
f x O h h
h
A
' = .
The same formula holds for the backward difference:
[ ]( )
( ) ( ).
V
' =
h
f x
f x O h
h

However, the central difference yields a more accurate approximation. Its error is
proportional to square of the spacing (if f is twice continuously differentiable; that is,
the second derivative of the function, f", is continuous for all x):
94

2
[ ]( )
( ) ( ).
o
' =
h
f x
f x O h
h

The main problem with the central difference method, however, is that oscillating
functions can yield zero derivative. If ( ) 1 = f nh for n uneven, and ( ) 2 = f nh for n
even, then ( ) 0 ' = f nh if it is calculated with the central difference scheme. This is
particularly troublesome if the domain of f is discrete.
A.2. Maximum-Likelihood for Kalman Filters
Several Maximum-Likelihood based methods can be used to compute and the desired
parameters when applying a Kalman Filter. Most conventional is to apply a numerical
optimization routine such as the Nelder-Mead algorithm (Lagarias et al., 1998). This is
implemented in Date & Wang (2009) and CDR (2011). Another algorithm more
commonly encountered in engineering and computer science is the EM-algorithm
(Ghahramani & Hinton, 1996).
The beginning of the Kalman Filter iteration depends on initial state
0
X and initial
covariance matrix
0
E and model parameters (in the above being B, A, u, H and Q).
Denoting as the vector of unknown parameters from the previous matrices, a joint
probability density function can be established as
1 1
1
) ( ( ,..., ; | ; )
T
T t t
t
f R R R f

=
=
[

With ( ) f denoting a multivariate density function. For the purpose of estimating the
system above remember the forecasting errors are Gaussian, leading to the multivariate
normal density function
95

1
1 2
2 1 1 2
1
2
( ) /
/ /
( )
( ) | |
t t
F
n
v v
f R e
F t

'

=
And in continuation hereof the log-likelihood

1 1
1
1
1
2
2 2
1
2
( ,..., ; log ) ) log ( | |
T
T t t
t
F
N
LogL R R v v F t

=
=
| |

|
\
'
.

(3.19)
With all inputs defined earlier.
From Equation (3.19) maximum likelihood can be performed by setting up the problem
1
max Log ( ,..., ) ;
T
L R R

A.3. Dickey Fuller test
In statistics, the DickeyFuller test tests whether a unit root is present in an
autoregressive model. It is named after the statisticians D. A. Dickey and W. A. Fuller,
who developed the test in 1979.
Null hypothesis:
1 t t t
y t e y c

= + o + +
Which the functions test against an alternative model:
1 t t t
ay t e y c

= + o + + where 1 a <
A.4. Quadratic optimization
Quadratic programming (QP) is a special type of mathematical optimization
problem. It is the problem of optimizing (minimizing or maximizing) a quadratic
function of several variables subject to linear constraints on these variables.
96

The quadratic programming problem can be formulated as:
Assume x belongs to
n
space. Both x and c are column vectors with n-elements (n1
matrices), and Q is a symmetric nn matrix.
Minimize (with respect to x)
1
2
x x c x f(x) Q = +
Subject to one or more constraints of the form:
Ax b s (inequality constraint)
Ex = d (equality constraint)
Where x indicates the vector transpose of x. The notation Ax b s means that every
entry of the vector Ax is less than or equal to the corresponding entry of the vector b
A related programming problem, quadratically constrained quadratic programming,
can be posed by adding quadratic constraints on the variables.

97

B. Summary of Immunization Models Features
Immunization
Approaches
Advantages Shortcomings
Cash Flow
Matching
Liability cash ows perfect
match
- High replication costs
- Only applicability in the sense of
deterministic implement
- Limitation of instruments uni-verse
Key Rate
Duration
Model
- The historical data of spot
rate curve shifts are also
taken into consideration.
- The choice of the key rates has a
strong impact on the immunization
results.
- The shape of the individual key rate
shifts are
unrealistic.
Duration
Vector
- Non-at yield curve
- Non-parallel and non-
innitesimal yield curve
shift
- The length of duration vector is
limited to 3-5 components.
Nelson Siegel
Duration
model
- The model can fit the
shape of yield curve quite
well.
- Parsimonious model make
forecast accurate
- Choosing parameter is intuitive.
- Estimating parameter is troublesome.
Principal
Component
Duration
Model
- The factors are selected
based on their contributions
to the total variance of key
rate shifts.
- The factors are
uncorrelated.
- This technique implies that
covariance matrix of key rate shifts is
constant, which is unable to deal with
the non-stationary time series behavior
of the interest rate movements.
98

- Based on the historical
data the components have
interpretations such as:
level, slope and curvature.


99

C. NET WORTH IMMUNIZATION - GAP ANALYSIS
C1. Duration Gap
The duration gap measures how well matched are the timings of cash inflows (from
assets) and cash outflows (from liabilities).
Notation
Dur
Gap : Duration Gap
A: present value of asset
L: present value of debt
r
A
: asset rate
r
L
: debt rate
S : surplus or net balance sheet portfolio value and S A L =
For an infinitesimal variation of asset rate we have:
A A A
dS dA dL
dr dr dr
=
L
A A L A
dr
dS dA dL
dr dr dr dr
=
The duration is given by (0.3):
( )
1
1
dS
D R
S dR
= +
Then:
1 1
- -
A L L
A A L A
D A D L dr
dS
dr r r dr

=
+ +

100

1
1 1
A L
A L
A A L A
r dr
dS A L
D D
dr r A r dr
| | +
=
|
|
+ +
\ .

We pose:

1
1
A L
A r
L
Du L
A
r dr
L
GAP D D
A r dr
+
=
+

Remark:
In the goal of simplification we can pose:
L A
dr dr = ,
then the duration gap becomes

1
1
+
=
+
Dur
A
A L
L
r L
GAP D D
A r

L A
r r = , then the duration gap becomes
Dur A L
L
GAP D D
A
=
Result
We have showed that :
A A
dV
A
GAP
dr 1+r
net
Dur
=
We can deduce that :
If
PV
GAP > 0 $ then NPV of portfolio increases with a fall of rate.
If
PV
GAP < 0 $ then NPV of portfolio decreases with a fall of rate.
If 0 =
PV
GAP $ then NPV of portfolio is insensible to the rate variation.
Remark
It is true for a small variation of rate.
101

C2. Convexity Gap
We have the relations
S A L
S A L
=
A = A A

Equity variation:
( )
2
2
2
1
2
A A
A A
dA d A
A r r
dr dr
A + A A
( )
2
2
2
2
2 2
1
2
L L L
A A
L L A A L A
dr dr d r
dL d L dL
L r r
dr dr dr dr dr dr
| |
| |
|
|
| |
|
\
A
\ .
.
A A + +
Hypothesis
2
2
0
.
L
A
L A
L
A
dr
dr
r r
d r
dr
|
|

=
=
=

( )
2
2
2
1
2
A A
A A
dA d A
A r r
dr dr
A + A A
( )
2
2
2
2
1
2
A A
L L
dL d L
L r r
dr dr
| | A A A +
S A L A = A A
( ) ( )
2 2
2 2
2
2 2
1 1
2 2
A A A A
L A L A
dA d A dL d L
S r r r r
dr dr dr dr
| | A + A A A A
But:
1 1
1 1
and
A L
L A
L A
dA dL
dr dr
D D
r A r L
= =
+ +

then
102

( ) ( )
2 2
2 2
2
2 2
1 1
1 2 1 2
L A A A A A
L A L A
S
A d A L d L
D r r D r r
r r dr dr
| | A A A +
+
A A
+

( ) ( )
2 2
2 2
2
2 2
1
1 1
1 1 2 2
Convexity Gap Duration Gap
A
A L A A A
A L A L
r
A L d A d L
S D D r r r
r A r dr dr
| |
| |
|
|
\ .
+
A A + A A
+ +

(3.20)
Remember that:

2
2
c
c
=
X
X
V
y
Conv
V

(X: asset (A) or liability (L))
Then (3.20) will become:

( ) ( )
2 2
2
1
1 1
1 1 2 2
Convexity Gap
Duration Gap
A
A L A A A L A
A L
r
A L
S D D dr AConv r LConv r
r A r
| |
| |
|
|
\ .
+
A + A A
+ +

( )
2
2
0
1
1
0
1 1 2

A
L
A
A
L A L A A L A
A L
A
L
D
D
S
Conv
r
A L L
Conv D D dr A Conv Conv dr
r A r A
r
r
| |
(
(
(
A =
(

| | ( + | |

+ =
| ( |

|
+ +
\ . ( \ .
(
(

(3.21)
It follows that, if we want the bank portfolio immunized to any adverse effect of
interest, the second equation of (3.21) must hold true to every value of asset and
interest change.
103

( )
2
2
1
1
0
1 1 2
A
A L A A L A
A L
r
A L L
D D dr A Conv Conv dr
r A r A
| |
| | + | |
+ =
|
|
|
+ +
\ .
\ .

2
1
0
1
0
A
A L
L
A L
r
L
D D
A r
L
Conv Conv
A
|
|
+
=

Finally, we must resolve
( )
2
1
0
1
1
1
0
2
P
A
A L
L
A L
r
L
D D
A r
L
Conv Conv
A
|
|
+
=

We can use the SOLVER of excel to compute the solution.

104

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