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Permanent and Transitory Factors Affecting the Dynamics of the Term Structure of Interest Rates

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  • Christophe Pérignon

    (Anderson School, UCLA)

  • Christophe Villa

    (ENSAI, CREST - LSM and CREREG - Axe Finance, France.)

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    Abstract

    This paper proposes a novel methodology, based on the Common Principal Component analysis, allowing one to estimate the factors driving the term structure of interest rates, in the presence of time-varying covariance structure. The advantages of this method are first, that, unlike classical principal component analysis, common factors can be estimated without assuming that the volatility of the factors is constant; and second, that the factor structure can be decomposed into permanent and transitory common factors. We conclude that only permanent factors are relevant for modeling the dynamics of interest rates, and that the common principal component approach appears to be more accurate than the classical principal component one to estimate the risk factor structure.

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    File URL: http://www.swissfinanceinstitute.ch/rp52.pdf
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    Bibliographic Info

    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp52.

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    Date of creation: Jun 2002
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    Handle: RePEc:fam:rpseri:rp52

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    Keywords: Term Structure of Interest Rates; Principal Component Analy-sis; Common Principal Component Analysis;

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