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Principal Component Analysis


  • PCA provides a single empirical description of term structure behavior which can be applied across all bonds
  • The basic advantage of this approach is that only volatility and structure of small number of principal components needs to described
  • Principal components are set up in such a manner that sum of the variances of these principal components are same as the sum of the variances of the individual rates
  • PCs are not correlated with each other.

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