Yield curves form a highly collinear system. The aim of PCA Analysis is to extract the main three uncorrelated time series (Level, Slope and Curvature) from the yields system to use in a subsequent analysis to identify trading opportunities across the entire yield curve.
PCA Analysis tool uses dimension reduction models, which includes Correlation and Variance-Covariance matrix models, and allow for sophisticated relative value trading strategies to be built with surprising ease.
PCA Analysis key benefits include:
- The ability to see through the ‘noise’ that bond yields creates and find the signals that capture the core dynamics of yield curves.
- Allows each yield rate to be expressed by its sensitivities to three uncorrelated drivers. This is crucial for RV analysis as it allows one to simplify and hedge/trade each driver separately.
- identifying the best way in which to express an overall market view, and to identify market-neutral curve dislocation trade opportunities.
- Trade identification on two or three selected points of the yield curve in order to increase and improve the flow of trade recommendations in the government bonds trading space.
- Constructing a rich/cheap relative value representation of any given yield curve.
Bond traders seeking to take positions across the yield curve can enjoy the benefits of using the PCA Analysis visualisation tool, as key information regarding the movement of the front end of the curve relative to the back end are captured in a rigorous way, therefore making it easy to construct PCA weighted slope trades that are neutral to market direction, and butterfly trades that are neutral to market levels and curve slope.