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Yield Curve Smoothing and Residual Variance of Fixed Income Positions

In: Inspired by Finance

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  • Raphaël Douady

    (Univ. Paris 1, CES)

Abstract

We model the yield curve in any given country as an object lying in an infinite-dimensional Hilbert space, the evolution of which is driven by what is known as a cylindrical Brownian motion. We assume that volatilities and correlations do not depend on rates (which hence are Gaussian). We prove that a principal component analysis (PCA) can be made. These components are called eigenmodes or principal deformations of the yield curve in this space. We then proceed to provide the best approximation of the curve evolution by a Gaussian Heath–Jarrow–Morton model that has a given finite number of factors. Finally, we describe a method, based on finite elements, to compute the eigenmodes using historical interest rate data series and show how it can be used to compute approximate hedges which optimize a criterion depending on transaction costs and residual variance.

Suggested Citation

  • Raphaël Douady, 2014. "Yield Curve Smoothing and Residual Variance of Fixed Income Positions," Springer Books, in: Yuri Kabanov & Marek Rutkowski & Thaleia Zariphopoulou (ed.), Inspired by Finance, edition 127, pages 221-256, Springer.
    • Handle: RePEc:spr:sprchp:978-3-319-02069-3_10
    DOI: 10.1007/978-3-319-02069-3_10
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