Journal of

Risk and Financial

Management

Article
The Use of Principal Component Analysis (PCA) in Building
Yield Curve Scenarios and Identifying Relative-Value Trading
Opportunities on the Romanian Government Bond Market
Andreea Oprea

Doctoral School of Finance and Banking, University of Economic Studies, 010961 Bucharest, Romania;
[email protected]

Abstract: Based on previous research addressing the use of principal component analysis (PCA) in
modeling the dynamics of sovereign yield curves, in this paper, we investigate certain characteristics
of the Romanian government bond market. We perform PCA on data between March 2019 and
March 2022, with emphasis on periods marked by extreme market stress, such as the outbreak of the
COVID-19 pandemic in March 2020 or the Russian military invasion in Ukraine in February 2022.
We find that on 25 March 2022, the first principal component explained 80.83% of the yield curve
changes, the first two 91.92%, and the first three 96.87%, consistent with previous results from the
literature, which state that the first three PCs generally explain around 95% of the variability in the
term structure. In addition, we observe that principal components’ coefficients (factor loadings) at
2 years were lower than those at 10 years, suggesting that in case of market sell-offs, yields at 10 years
increase more than those at 2 years, leading to yield curve steepenings. Interestingly, we observe
that the explanatory power of the first PC increases significantly following extreme market events,
Citation: Oprea, Andreea. 2022. The when interest rates’ movements tend to become more synchronized, leading to higher correlations
Use of Principal Component between tenors. We also employ PCA to check for relative-value (RV) trading signals and to assess
Analysis (PCA) in Building Yield the historical plausibility of yield curve shocks. We found that while both explanatory power and shape
Curve Scenarios and Identifying plausibility were characteristics of the yield curve dynamics during the outbreak of the COVID-19
Relative-Value Trading pandemic, the magnitude of the market movement registered in mid-March 2020 was unlikely from
Opportunities on the Romanian
a historical perspective. Finally, we use a forecasting model to derive the entire structure of the
Government Bond Market. Journal of
Romanian yield curve while also incorporating the trader’s view on a few benchmark yields.
Risk and Financial Management 15:
247. https://doi.org/10.3390/
Keywords: principal component analysis (PCA); government bond market; bond yields; yield curve
jrfm15060247
modeling; yield curve scenarios; Romanian bond market; relative-value trading
Academic Editor: Hai Lin

JEL Codes: G12; G14; G28; E43; G32; H6

Received: 2 May 2022
Accepted: 26 May 2022
Published: 31 May 2022

Publisher’s Note: MDPI stays neutral 1. Introduction

with regard to jurisdictional claims in
Principal component analysis (PCA) is a widely known statistical tool used to describe,
published maps and institutional affil-
iations.
investigate, model, and explain complex multivariate real-life structures in a parsimo-
nious way, while also solving for the correlation problem. Principal components are by
construction uncorrelated composite variables, as they are obtained from the original
interdependent variables via an orthogonalization transformation.
Copyright: © 2022 by the author. While PCA has been extensively used for decades in various fields, such as natural
Licensee MDPI, Basel, Switzerland. sciences or geology, in finance, it was employed in the 1980s, first, in equity markets and
This article is an open access article afterwards in fixed income markets, and it has become of interest to academics and practi-
distributed under the terms and tioners ever since (Golub and Tilman 2000, p. 93). However, due to the less intuitive nature
conditions of the Creative Commons of principal components in direct market movements, for many years, they have been of
Attribution (CC BY) license (https:// relatively limited usage in trading and portfolio management.1 Eventually, PCA has gained
creativecommons.org/licenses/by/
terrain so that, nowadays, large financial institutions, such as J.P. Morgan (Yau 2012) or Credit
4.0/).

J. Risk Financial Manag. 2022, 15, 247. https://doi.org/10.3390/jrfm15060247 https://www.mdpi.com/journal/jrfm

J. Risk Financial Manag. 2022, 15, 247 2 of 37

Suisse, use this tool to perform portfolio risk management and develop trading strategies that
are PCA duration adjusted (Credit Suisse Securities Research and Analytics 2012).
In fixed income finance, principal components (PCs) are primarily used to reduce
the dimensions of the risk factor spectrum for those instruments that are interest rate
sensitive and for options portfolios (Alexander 2008). Actually, principal components can
be attributed a very intuitive interpretation, as they depict the most characteristic yield
curve shocks. Research in the field has revealed that the first three principal components
can be interpreted as the level, steepness, and curvature of the yield curve and, generally,
explain between 90% and 95% of returns on fixed income instruments.
In this paper, we analyzed how the PCA method succeeds in describing the dynamics
of the Romanian sovereign yield curve at different points in time, especially in the proximity
of major events, such as the outbreak of the COVID-19 pandemic or the military escalation
of the Russian–Ukrainian conflict. We find that on 25 March 2022, the first principal
component explained 80.83% of the yield curve changes, the first two 91.92%, and the first
three 96.87%, results that are consistent with previous works from the literature.
Moreover, we observed that the explanatory power of the first principal component
(the yield curve variance explained by the first PC) increases significantly following extreme
market events. For example, on 28 February 2020, the first principal component explained
only 70.52% of the yield curve variability, the first two principal components 90.35%, and
the first three 95.71%. The explanatory power of PCs increased in the following weeks,
such that on 20 March 2020,2 the first PC explained 91.51%, the first two 98.87%, and the
first three 99.62%. These findings are consistent with those of Golub and Tilman (2000), in
the sense that interest rate movements tend to become more synchronized in a severely
distressed market environment, leading to higher correlations between maturities. As such,
while the correlation coefficient between the 2-year and the 10-year yields was 0.51 on
28 February 2020, within less than a month, it reached 0.82.
Additionally, we observed that factor loadings corresponding to the 2-year maturity
are lower than those corresponding to the 10-year maturity, suggesting that in the case
of market sell-offs, yields at 10 years will increase more than those at 2 years, leading
to a steepening of the yield curve. Similarly, in situations of market rallies, long-term
interest rates will decrease less than short-term ones, resulting in a flattening pattern. When
counting the actual patterns observed in the market, we found that, indeed, bull flattening
and bear steepening patterns appeared to have dominated the period analyzed, between
March 2019 and March 2022.
Finally yet importantly, we deployed PCA to highlight situations where segments of
the yield curve were too rich or too cheap, and thus identified some real relative-value
(RV) trading opportunities. Additionally, we performed an assessment of the historical
plausibility of extreme market movements while providing actual scenario likelihoods.

2. Literature Review
Good estimates of the term structure of interest rates are of extreme importance to
policymakers, investors, and basically any entity dealing with interest rate exposures.
Among the first estimation methods was the smoothed bootstrap, introduced by Bliss and
Fama (1987), in which discreet spot rates are derived from market data via a bootstrapping
process, and afterwards, a smooth and continuous curve is fitted to the data. Although
several curve fitting spline methods3 have been developed, they encountered a range of
critics due to their undesirable economic properties and lack of intuitive interpretation
(also considered “black box” models).
The one factor model deployed by Vasicek (1977) is one of the most pioneering and
notable equilibrium models, where the instantaneous short-term interest rate follows a
mean-reverting process. However, the Vasicek model was considered flawed because it
allowed the short term to become negative, which was not consistent with global yields at
that time. As a response, Cox et al. (1985) modelled the short-term rate such that the square
root of the interest rate level was proportional to the standard deviation of changes in the
J. Risk Financial Manag. 2022, 15, 247 3 of 37

interest rate. The main drawback of these term structure models is that even though they
allow for desirable data manipulation, they tend to be inconsistent with actually observed
market yields (Kumar 2019).
On the other hand, arbitrage-free models are calibrated with market data, such that
provided values of the short-term yields are consistent with the current market rates. In
this scope, Hull and White (1990) extended the Vasicek model to allow for a time-varying
drift in the short rate. Eventually, the work of Heath et al. (1992) focuses on the evolution
of forward rates.
Piazzesi et al. (2019) uses “affine” models to explain changes in the term structure.
The main advantage of these models lies in their functional-form assumptions regarding
the yield curve (Piazessi 2010), resulting in tractable pricing formulas, and thus avoiding
the computational burden implied by Monte Carlo methods.
While the aforementioned models are theorized on the “equilibrium” and “arbitrage-
free” assumptions, another class of models develops parametric curves that are flexible
enough to explain a wide variety of observed term structure shapes.
Such models are the ones developed by Nelson and Siegel (1987) and Svensson (1994,
1996). The NS model is being extensively used by both theoreticians and practitioners in
central banks and policymakers (Bank of International Settlements 2005; European Central
Bank 2020; Annaert et al. 2012), especially due to their factor interpretation (Litterman and
Scheinkman 1991) of the term structure (level, slope, and curvature) and their parsimonious
construction, as the sum of a polynomial times an exponential decay plus a constant. Apart
from the aforementioned three factors, the Svensson model also incorporates a “hump”
factor, which allows for an even more complex shape of the term structure. The Nelson and
Siegel (NS) model has been used on a large scale by fixed income portfolio managers for
immunization purposes (Barrett et al. 1995 and Hodges and Parekh 2006). In the academic
field, Dullmann and Uhrig-Homburg (2000) used the NS model to perform interest rate
risk calculations for the German bond market.
Fabozzi et al. (2005) and Diebold et al. (2008) compared results obtained from the NS
approach with outputs from other term structure models and discovered that the former
performs well, especially in the case of longer forecast horizons. Martellini and Meyfredi
(2007) employed the NS model for the calibration of yield curve parameters and to estimate
the value-at-risk for fixed income portfolios. Last but not least, the estimates obtained from
the NS model can be used as an input for affine term structure models (Coroneo et al. 2008).
Though largely used, the NS model does have its drawbacks, the main one being
that it is highly nonlinear. As indicated by Diebold et al. (2008), the high degree of
correlation between NS model risk factors may often lead to difficulties in estimating the
parameters correctly.
To address the multicollinearity problem, modern machine learning techniques can
model the yield curve dynamics without necessarily solving for an underlying parametric
structure (Asare 2019).
Principal component analysis (PCA) is an unsupervised learning technique4 used to
reduce the dimensions of a large set of correlated features by transforming them into
uncorrelated variables. This is performed throughout an orthogonalization process, which we
will explain in more detail later in this paper.
The work of Litterman and Scheinkman (1991) provided evidence that principal
components derived from market interest rates are a valuable information resource for fixed
income portfolio managers and market risk officers, particularly due to their contribution
as hedging tools. They identified three factors (accounting for level, slope, and curvature)
that explained approximately 98% of the returns on U.S. Treasuries.
One of the most comprehensive works in the literature that addresses the applied use
of PCA in the risk management of fixed income instruments was written by Golub and
Tilman (2000). They emphasize that the principal components’ factor loadings reflect the
historical relationship between key spot rates, and have an intuitive interpretation, as they
J. Risk Financial Manag. 2022, 15, 247 4 of 37

visually depict the shape of the most dominant yield curve changes, meaning the principal
components (Golub and Tilman 2000).
Golub and Tilman (2000) observed that the shape of the first principal component is
similar to the one exhibited by the term structure of volatility (TSOV) of movements in U.S.
Treasury spot rates, especially in business-as-usual times, when—except for the very short
end of the yield curve—interest rates are typically highly correlated (Golub and Tilman
2000, pp. 102–3). Moreover, yield changes tend to become even more synchronized in
times of market distress and financial turbulence, given the rise to even higher correlations
(Ronn 1996). They compared the shape of the first principal component with that of the
TSOV on 30 September 1996 and observed that the two curves were almost identical
for the most volatile zone of the term structure (2–10 years) and diverged moderately in
the proximity of the short and long ends of the yield curve. Golub and Tilman (2000)
also observed that on 30 September 1996, the first principal component derived from the
covariance matrix of changes in U.S. key interest rates5 explained almost 93% of the spot
curve variability. The first two principal components explained 97%, and the first three,
99%. On 31 December 1998, the explanatory power of principal components declined, such
that this time the first PC only explained 83% of the yield curve variability, the first two
PCs explained 90%, and the first three 95%. It is of notable importance to specify that
the explanatory powers of PCs are functions of the market environment. As such, in the
aforementioned examples, as the front end of the yield curve became decoupled from the
rest of the spot rates in fall 1998, the factor loadings of the first principal component in the
case of the 3-month and 1-year yields declined dramatically.
Another interesting finding by Golub and Tilman was that for the 2-year rate, the factor
loading of the first PC was larger than that of the 30-year rate, suggesting that in the case of
market rallies, the decrease in yield for the 2-year tenor will be more pronounced than for
the 30-year tenor, leading to a steepening of the yield curve (Golub and Tilman 2000, p. 105).
Golub and Tilman (2000) also introduced the concept of historical plausibility of interest
rate shocks, representing the mix of three major features (explanatory power, magnitude plau-
sibility, and shape plausibility) in assessing the likelihood of specific yield curve scenarios. As
such, according to their computations, the shape plausibility of the yield curve movement
on 9 October 19986 was 94%, while its explanatory power was 82%, both suggesting that the
shape of this shock was characteristic of the dynamics of yields and historically plausible.
However, the low magnitude plausibility of only 1% indicated that the dimension of such
sell-off was uncommon from a historical perspective (Golub and Tilman 2000, p. 120).
A paper released by Nogueira (2008) assumes that a fixed income trader or portfolio
manager is already able to provide a view on a few benchmark yields or a combination
of yields (Nogueira 2008) based on the trader’s experience and knowledge of market
conditions. Principal component analysis is afterwards used in a model that incorporates
the trader’s view on a specific yield or a set of yields to derive the entire structure of the
spot rate curve.
More recent research addressing the use of PCA in explaining yield curve dynamics
was performed by Asare (2019), who extended the work of Bolder et al. (2004), by applying
the PCA method to zero-coupon bond data from the Canadian bond market, between 2004
and 2018 (the analysis conducted by Bolder et al. comprised data for the period of 1986
to 2003). Bolder et al. (2004) observed that the first three principal components explained
99.5% of the data variability between 1986 and 2003, which was consistent with the later
findings of Asare for the period following the financial crisis. Furthermore, Asare compared
the results obtained from a traditional econometric model (the Vasicek model) with those
derived from modern machine learning techniques (in this case, the PCA) and concluded
that the principal component analysis outperformed the Vasicek model in fitting the yield
curve (Asare 2019, p. 62).
In our study, the first goal was to analyze how the principal component analysis
(PCA) method manages to describe the dynamics of the Romanian sovereign yield curve at
different points in time, especially before and after major events, such as the COVID-19
J. Risk Financial Manag. 2022, 15, 247 5 of 37

pandemic, the transition to hawkish monetary policy measures due to elevated levels of
inflation, or the military escalation of the Russian–Ukrainian conflict. In the second part,
we intended to extend the concepts introduced by Golub and Tilman (2000) of historical
plausibility of yield curve scenarios to the Romanian government bond market. That
is, we computed the measures of historical plausibility (explanatory power, shape plausibility,
and magnitude plausibility) for different yield curve shocks, while quantitatively assessing
for their historical likelihood. Eventually, we used the forecasting model developed by
Nogueira (2008) to derive the entire structure of the Romanian yield curve while also
incorporating the trader’s view on a few benchmark interest rates.

3. Principal Component Analysis

3.1. Key Rates versus Principal Components
Measuring yield curve risk via deterministic approaches, such as key rates, is perhaps
the most intuitive and most widely used practice among risk and portfolio managers.
However, one drawback of using key rates is that their complex correlation and volatility
structure make them less efficient in providing inferences on the yield curve movements
from a statistical perspective (Golub and Tilman 2000, p. 93). Still, they are very useful in
assessing certain patterns of the term structure as, for example, the likelihood of a yield
curve steepening or flattening between two key maturities that exhibit high correlation.
The key rates approach, however, does not answer a whole class of questions, such as
what would the entire yield curve normally look like if the spot rate for a specific maturity
changes by a given number of basis points. This is one aspect we would like to know if we
had a view only on a specific tenor.
Principal component analysis not only addresses this type of question, but also pro-
vides a probabilistic approach in the process of generating yield curve scenarios, as we will
discuss in more detail in Section 5 of the present article. Generating yield curve scenarios of
which shape and magnitude plausibility can be quantitatively measured is one particular
feature of PCA that this paper addresses. However, the extensive use of this powerful
dimensionality reduction tool goes beyond the scope of this article, as it also provides—
among other things—valuable risk management techniques, with Monte Carlo simulation
value-at-risk (VaR) being the most notable.

3.2. PCA Methodology

Principal component analysis (PCA) is being extensively used, particularly in discrete
time finance, with the main purpose of reducing the dimensions of risk factors in the case
J. Risk Financial Manag. 2022, 15, x FORofPEER
instruments
REVIEW that are sensitive to movements in interest rates (Alexander 2008, p. 59).
6 ofThe
39
technique involves an orthogonalization transformation (Figure 1) of a highly correlated
system, such as the term structure of market yields.

Figure 1. Orthogonalization transformation of interdependent interest rates into uncorrelated princi-

pal components.
Figure 1. Orthogonalization transformation of interdependent interest rates into uncorrelated prin-
cipal components.
The concepts of eigenvectors and eigenvalues are of utmost importance when deal-
ing with PCA. Essentially, eigenvectors and eigenvalues are components that explain
The concepts of eigenvectors and eigenvalues are of utmost importance when deal-
the volatility of a given term structure. Principal components usually exhibit particular
ing with PCA. Essentially, eigenvectors and eigenvalues are components that explain the
volatility of a given term structure. Principal components usually exhibit particular
shapes and graphically depict the level of shifts across maturities (Farid and Salahuddin
2010). However, that limited intuition behind PCs resulted in their scarce use in portfolio
management and trading for a prolonged period.
J. Risk Financial Manag. 2022, 15, 247 6 of 37

shapes and graphically depict the level of shifts across maturities (Farid and Salahuddin
2010). However, that limited intuition behind PCs resulted in their scarce use in portfolio
management and trading for a prolonged period.
Golub and Tilman (2000) observed that the shape of the first principal component
resembles that of the term structure of volatility (TSOV) of changes in the U.S. spot
rates (Golub and Tilman 2000, p. 103), given that—except for the very short maturities—
movements in U.S. Treasury yields are generally highly correlated during business-as-
usual regimes.
The work of Golub and Tilman (2000) clearly brings light to a common misunder-
standing that the first principal component should be automatically assumed to represent
a parallel yield curve shock. While the first principal component does reflect more of a
level shift in interest rates (Ronn 1996, p. 2), it should not be implicitly assumed to be a
parallel movement.
Moreover, the assumption that the shape of the first principal component is parallel
determines principal components to become correlated in case a proper adjustment of
other principal components is not applied (Golub and Tilman 2000, p. 95). Essentially,
principal components represent linear combinations of changes in the level of key rates,
both (principal components and key rates) being random variables:
n
pi = ∑ j=1 pi,j . ∆y j . (1)

where pi are principal components, ∆r j are changes in the level of key rates, and pi,j
represent the coefficients of principal components or factor loadings. In mathematical terms,
principal components are vectors, and Equation (1) can be rewritten in a matrix format
as such:
1,1 · · · p1,n
  p 
∆y1

p1
. .. ..  . . . 
 ..
. . . =  . .  (2)
pn p · · · pn,n ∆y n
n,1

Given that the matrix of principal components’ coefficients is orthogonal by construc-

tion, the reverse transformation of [3.1.] and [3.2.] is also valid:
n
∆yi = ∑ j=1 p j,i p j . (3)

Additionally,
 p ···


∆y1 1,1 pn,1  p 
1
. .. .. . . .
 ..
 ...  =  . .  (4)
∆yn p1,n ··· pn,n pn

Movements in systematic risk factors are considered to follow a joint multivariate

normal distribution with zero mean. Thus, principal components shall be deducted from
covariance matrix ∑ changes in risk factors, which in this case are represented by changes
in key rates.
This is performed throughout an optimization process by repeatedly searching through
all possible combinations of key rates’ movements that explain the largest proportion of the
total system variance. The process is described in detail in the work of (Golub and Tilman
2000, p. 98).
Mathematically, the factor loadings of the principal components are the eigenvectors of
the covariance matrix ∑:    
pi,1 pi,1
∑  . . .  = λi  . . .  (5)
pi,n pi,n
J. Risk Financial Manag. 2022, 15, 247 7 of 37

Equation (5) can be rewritten in terms of matrix notation as such:

T
··· 0 ··· ···
    
λi p1,1 p1,n p1,1 p1,n
 .. ..  =  .. ..   .. .. 
.  ∑ .
.. .. .. (6)
. . .   . . . . 
0 · · · λn pn,1 ··· pn,n pn,1 ··· pn,n

Equivalently,
Λ = PΣPT (7)
where Λ is a diagonal matrix containing the eigenvalue Λi on the diagonal and zeros else-
where and P is the matrix of principal components’ coefficients (factor loadings). Given that
the rows of matrix P are linearly independent unit-length vectors, P is an orthogonal matrix:

P−1 = P T (8)

Thus, given that variances and covariances are measures of central tendency, what
PCs actually represent are ways in which term rates composing a yield curve can deviate
from their mean levels.
Additionally, in terms of interpretation, eigenvectors are the components that explain
the volatility of a given term structure, while an eigenvalue assigns the corresponding
eigenvector with a level of relative importance (Farid and Salahuddin 2010, pp. 43–45). The
greater the value is, the greater will be the percentage of total variability explained by that
particular eigenvector. Thus, PCA provides an alternative description of the dynamics of a
yield curve by transforming the information contained in the covariance matrix of yield
changes into two different descriptive statistics:
The vector λ = (λ1 , . . . λ2 ) of the variances of principal components;
The matrix P of the factor loadings associated with the principal components.
Given that any change in the yield curve can be explained by the set of uncorrelated PCs,
the sum of the principal components’ variances will equal the system’s total variability:
n
Total Variability = ∑ i =1 λ i . (9)

It can be shown that the ratio of a given variable’s variance to the total variability of
the system represents the amount of variability explained by that particular variable. In the
case of principal components, that is the percentage of the total variability of changes in the
yield curve explained by a particular PC:

λi
Principal Component Variability = ζ i = (10)
∑nj=1 λ j

The amount of variability of yield curve movements explained by a given principal

component is called explanatory power and has an important role in providing insights into
the dynamics of interest rates. For instance, explanatory powers of principal components
can be used to determine the number of risk factors needed to approximate the changes
in interest rates with sufficient accuracy (Golub and Tilman 2000, p. 100). For example, in
environments where the first principal component’s explanatory power is more than 95%,
describing yield curve movements with a single risk factor is the optimal choice. However,
when the explanatory power of the first PC is low, two or even three principal components
might be required. As stated earlier, in most market environments, the first three PCs
generally explain almost completely the dynamics of a yield curve.

4. Building Yield Curve Shocks of Deterministic Probability

4.1. The Probabilistic Framework of Interest Rate Scenarios
Apart from describing the historical relationship among key interest rates, the factor
loadings of principal components (p1 , p2 . . . pn ) also have a very intuitive interpretation,
J. Risk Financial Manag. 2022, 15, 247 8 of 37

as they visually reflect the most prominent changes in the yield curve structure, that is,
principal components.
It can be shown that the principal components’
√ yield curve shocks can be generated
by multiplying the one standard deviation λ1 of PCs with the factor loadings’ vectors
(p1 , p2 . . . pn ) (Golub and Tilman 2000, p. 109). Under the assumption that changes in
interest rates are normally distributed, any yield curve movement corresponds to a re-
alization of a standard random variable.7 Therefore, in addition to hypothetical what-if
scenarios formulated in terms of yield curve shocks with the purpose of approximating
potential losses corresponding to a given interest rates’ movement (via key rate durations),
principal components’ shocks have the advantage of allowing for the computation of the
likelihood associated with a particular movement. For example, if a specific interest rate
shock corresponds to a realization of three standard deviations of the underlying standard
normal variable, then this yield curve scenario will be considered historically unlikeable
(Golub and Tilman 2000, p. 108). We will further describe the process used by Golub and
Tilman to determine the likelihood of specific yield curve scenarios, which we will apply
later in this paper for the case of the Romanian government bond market.
Since both key rates and principal components can be judged as random variables,
specific interest rate movements will represent realizations of ∆yi and p1,n corresponding
to a vector of coefficients. For instance,

z = (z1 , . . . , zn )KR (11)

represents a yield curve shock written in terms of key rate changes, where the first key rate
is shocked by z1 basis points, the second one with z2 basis points, and so on. The same
yield curve shock can be written in terms of a principal component’s realization:

z = (v1 , . . . , vn ) PC (12)

Recall from Equations (1)–(4) that the matrix of principal components’ coefficients
is orthogonal by construction, so when applied to interest shock z, Equation (4) can be
formulated as follows:

1,1 · · · pn,1
  p    
z1 v1 n pi,1
. .. .. . . =
 ..
. . . =  ..
. .  ∑  . . .  vi (13)
zn p1,n · · · pn,n v n i = 1 p i,n

Equation (13) reveals that any yield curve movement can be written as a sum of the
factor loadings of principal components multiplied by the realization of the appropriate
principal component (Golub and Tilman 2000, p. 109). For any arbitrary change in the level
of yields, there is a unique combination of principal components’ realizations, and they can
be determined analytically.
An important corollary to Equation (13) is related to the possibility of building interest
rate shocks from PCs. In the orthogonal coordinate system of PCs, one standard deviation
change in the first principal component is represented as such:
p 
One SD PC1 = λ1 , 0 . . . , 0 (14)
PC
√
where λ1 , as before, represents one standard deviation of the first principal component.
In terms of changes in key rates, the shock of the first PC can be written as follows:

··· pn,1 √λ  

 
p1,1
1
 .. ..  . . .  = pλ p , . . . , pλ p

One SD PC1 =  . .. (15)
. .  1 1,1 1 1,n
KR
p1,n ··· pn,n 0
J. Risk Financial Manag. 2022, 15, 247 9 of 37

When dealing with interest rate shocks of principal components, practitioners gener-
ally refer to Equation (16). Since one standard deviation is determined for a specific time
horizon (daily, monthly, annually, etc.), the corresponding principal component shocks will
be represented within the same horizon.
Yield curve shocks z and x are considered to be of the same shape if one can be
determined from the other by scaling it with a nonzero number c:

(z1 , . . . , zn )KR = (cx1 , . . . , cxn )KR . (16)

As mentioned previously, given that any interest rate shock can be attributed a par-
ticular realization of a standard normal variable, by establishing the relationship between
an arbitrary yield curve shock z and its corresponding realization, it will allow for the
measurement of the probability of z to occur.
The probability associated with z can be computed by first constructing a vector
(ξ 1 , . . . , ξ n ) of unit length that has the same shape as z:

z = |z|(ξ 1 , . . . , ξ n )KR (17)

where z = |z|(ξ 1 , . . . , ξ n )KR represents the length of vector z.

Similar to principal components, Equation (1) can be rewritten in terms of a new
random variable ξ that represents a different linear combination of key rates:
n
ξ= ∑i=1 ξ i ∆yi . (18)

Additionally, its corresponding variance, just as Equation (7), is given by the follow-
ing formula:
σ2 ( ξ ) = ( ξ 1 , . . . , ξ n ) Σ ( ξ 1 , . . . , ξ n ) T (19)
Afterwards, a new orthogonal basis of the space of yield curve changes can be con-
structed via optimization. Just as any yield curve shock can be represented as a function of
principal components’ realizations, the result corresponding to the newly formed coordi-
nate system can be derived as well:

∆y1
   
ξ1
 . . .  = . . .ξ + other elements o f the basis (20)
∆yn ξn

The one standard deviation shock of the same shape as z can be described as follows:

(σ(ξ) ξ 1 , . . . , σ(ξ ) ξ n )KR (21)

ξ
and is a standard normal variable.
σ(ξ )
The general results stated in Equation (20) can be applied to particular realizations
of random yield changes, meaning the z shock. Thus, given its orthogonality, z is fully
explained by the first element (ξ ) of the new coordinate system:
   
z1 σ(ξ ) ξ 1
|z|
z = . . . =  . . .  (22)
σ(ξ )
zn σ(ξ ) ξ n

|z|
where σ(ξ) is the realization of the standard normal variable corresponding to z.
Equation (22) can be employed in a wide range of applications, including the compu-
tation of a standard deviation of the parallel yield curve shock. This, in turn, will allow for
the construction of a probabilistic framework for scenario analysis.
In Section 5 of this paper, we show how to compute the annualized one standard
deviation of a parallel yield curve shock with an example from the Romanian government
J. Risk Financial Manag. 2022, 15, 247 10 of 37

bond market. Afterwards, we estimate the probabilities associated with various parallel
movements (in basis points) across different time horizons.

4.2. Measures of Historical Plausibility of Yield Curve Shocks (Explanatory Power, Magnitude
Plausibility, and Shape Plausibility)
The universe of imaginable interest rate scenarios is unlimited, and measuring the
magnitude of potential losses associated with specific yield curve scenarios was particularly
the area of utmost interest. However, it is important to evaluate how characteristic of the
recent dynamics of interest rates a specific hypothetical shock is. The measures of historical
plausibility explained below are aimed to provide a perspective on how and whether given
yield curve scenarios are actually prone to happen.
Nevertheless, only assessing the impact of historically plausible interest rate scenarios
is not enough, as less probable scenarios resulting from highly uncharacteristic market
movements should also be taken into account, like throughout stress testing.
As stated before in this article, explanatory power represents the percentage of the total
system variability explained by a specific yield curve shock. It is therefore a measure of
how representative an interest rate shock is of the recent yield curve dynamics, and it is
considered the simplest measure of plausibility. The first principal component has, by
construction, the largest explanatory power, and it is the most characteristic representation
of the yield curve dynamics.
While explanatory power reviews how characteristic a specific interest rate shock is
of the recent yield curve dynamics, magnitude plausibility indicates whether the size of a
specific shock can be deemed too large from a historical approach. For instance, a low
magnitude plausibility suggests that the shock is unusually large judging by the recent
volatility of yields.
When estimating magnitude plausibility, a symmetrical approach should be imple-
mented, in the sense of assessing the joint probability of both an increase and a decrease in
interest rates by a given number of basis points, over the course of a specified time horizon.8
In general terms, the magnitude plausibility of a given yield curve shock z can be
computed by using the following formula:

mpl (z) = P(N(0, 1) ≤ −|S| or N(0, 1) ≥ |S|) = 2P(N(0, 1) ≥ |S|) (23)

where P() represents the probability, N(0,1) a standard normal variable, and S a realization
of a standard normal variable associated with a specific interest rate shock z.
The measure of plausibility introduced above implicitly assumes that irrespective of
their current level, market yields are as likely to rally as they are to sell off (Golub and
Tilman 2000, p. 117). However, this hypothesis might not be realistic in certain market
environments; more specifically, if yields are at their historical highs, the probability of
a reversal might seem higher than that of a trend continuation. To address these aspects,
magnitude plausibility can be enriched to account for the mean reversion of interest rates by
incorporating conditional probabilities. However, it is worth mentioning that additional
mean-reverting processes should be considered only if the market is not believed to have
undergone a permanent shift (Golub and Tilman 2000, p. 117). The use of conditional
probabilities to improve the estimation of magnitude plausibility is beyond the scope of
this paper.
Shape plausibility is another important feature that helps in characterizing the dynamics
of interest rates. Golub and Tilman (2000) proposed a more unconventional method
to measure shape plausibility, inspired by modeling techniques often used in medicine,
behavioral and environmental sciences, or other domains where subjective expert judgment
is being extensively used. The measure they proposed makes use of two concepts obtained
via PCA:
1. The representation of any yield curve shock as a set of principal components’ realizations;
2. The ranking of principal components given by their explanatory powers ζ i .
J. Risk Financial Manag. 2022, 15, 247 11 of 37

More specifically, it is reasonable to think that if an interest rate shock is very charac-
teristic of recent yield curve movements, then its decomposition into principal components
should, to some extent, be consistent with how the total variability of yields is explained
by PCs. Thus, a yield curve shock is said to be the most representative if each principal
component’s contribution (θ M,i ) to this shock is the same as its explanatory power (ζ i ).
Therefore, the vector representing the decomposition of the most representative shock into
principal components will be precisely the vector of the explanatory powers:
PC Decomposition of the Most Representative Shock

(θ M,1 , . . . , θ M,n ) = (ζ 1 , . . . , ζ n ) (24)

On the other hand, since the last principal component has, by construction, the lowest
explanatory power, the composition of the least representative interest rate shock will have
the following structure:
PC Decomposition of the Least Representative Shock

(θ L,1 , . . . , θ L,n ) = (0, . . . , 0, 100) (25)

The metric of shape plausibility spl (z) would thus be computed as a number between
0% and 100% that can be assigned to a certain interest rate shock:

spl : z → x є [0%, 100%] (26)

The most representative shock will have a shape plausibility of 100%, while the least
representative one 0%.
There are various ways in which the measure of shape plausibility can be defined,
and one possible approach is exposed by Golub and Tilman (2000). After defining a
hypothetical yield curve shock z in terms of principal components’ realizations (v1 , . . . , vn ),
the contribution of each principal component to z will be defined as the percentage of the
squared length of z due to vi , as such:

v2i
θi = (27)
∑nj=1 v2j

The functional form of shape plausibility proposed by Golub and Tilman enables the
comparison between the principal component decomposition of a given builder shock with
those of the most and least characteristic shocks:
q
2
∑in=1 (θi − θ M,i )
spl (z) = 1 − q . (28)
2
∑in=1 (θ M,i − θ L,i )

where θi , θ M,i , θ L,i represent the principal component decomposition of the given yield
curve shock, the most characteristic shock, and the least characteristic shock, respectively.
It is of utmost importance to mention that all measures of interest rate shocks’ plausi-
bility (explanatory power, magnitude plausibility, and shape plausibility) are prone to substantial
changes depending on the market conditions. More interpretations based on the historical
perspective of the Romanian government bond market are presented in Section 5 of the
present paper.

4.3. Incorporating Trader’s View into Yield Curve Forecasts

Although financial modeling plays a key role in forecasting interest rates, traders
and portfolio managers often base their decision on expert judgment, encompassing both
experience and intuition.
In a paper written by Nogueira (2008), the author assumes that a portfolio manager
or trader is able to provide a view of a few benchmark yields or a combination of yields
J. Risk Financial Manag. 2022, 15, 247 12 of 37

(Nogueira 2008, pp. 3–6), and then derive a forecast of the entire term structure. His model
is also built on the theory of principal components (PCA), and its main contribution is in
scenario analysis, where the trader can split the forecasting process into two steps: the
forecasting of a few benchmark yields based on macroeconomic developments and own
expert judgment, and the second part, where the model developed in the paper is used to
derive the entire yield curve while incorporating the trader’s view.
Nogueira uses a model that is tractable,9 does not depend on any type of probability
distribution,10 is linear, can easily be extended for higher dimensionality data, does not
assume any structure for the risk factors, and provides intuitive forecasts.
Given a group of m random variables to forecast and a group of n views on linear
combinations of the respective variables, with n ≤ m, Nogueira (2008) derives the scenario
estimations for the m random variables and assigns a standard error to each variable. This
is performed by mapping the n views into a forecast for the first n principal components
of the set of normalized random variables (Nogueira 2008, p. 2). The mapping is linear,
unique, and correct under the hypothesis that the trader’s view can be fully explained by
the n most relevant principal components. Thus, this approach assumes that the dynamics
expressed in the views are the consequence of broad market movements (decision of central
banks, GDP results, surprises about inflation, or other macroeconomic events) rather than
the specific behavior of individual variables—which are captured in the remaining m–n
principal components.
Without entering into further details in regard to the model developed by Nogueira,11
we expose the central and most important theorem from his work. It states that under
the hypothesis that all yield curve variations expressed in the views can be fully explained
by movements in the first n PCs of normalized yield changes, the forecasted yield curve at
time t + 1 is given by the following equations:

E[yt+1 ] = yt + µ + DA (∆q − Vµ) (29)

 
Var[yt+1 ] = D AΩA T + BΛ̂B T D. (30)
 
where Am x n = W e VDW e −1 , Bm x (m−n) = Am x n = ( Im − AVD ) W, e and Im is the
identity matrix.
The theorem above offers a point estimate to the vector of yields yt+1 and the covari-
ance matrix of this forecast. While DA:Rn → Rm maps the n views into a forecast of changes
for the m interest rates, DB:Rm−n → Rm maps the error of approximation using PCA into an
error for the random variables. Together, they account for the construction of the expected
yield curve that is consistent with that of the trader’s view.
We can see that Var[yt+1 ] sums up two clearly defined structures: DAΩA T D, which
captures the trader’s uncertainty on the views, and DBΛ̂B T D, which captures the approxi-
mation error.
In order to use Nogueira’s theorem to perform a yield curve forecast, we need the yield
curve at time t, a set of subjective views {V, qt+1 , Ω}, the mean vector, and the covariance
matrix of yield changes. In the case of yield curves, it is acceptable to set µ = 0, as it is
generally very low.
In Section 5 of this article, we use data from the Romanian government bond market
to perform a series of weekly forecasts at different points in time, including before and
after large market movements, such as the ones caused by the COVID-19 pandemic or the
Russian–Ukrainian military conflict. Eventually, we compare our estimates with realized
market yields.

5. PCA Applied to the Romanian Government Bond Market

5.1. Explanatory Powers of Principal Components
For the purpose of our analysis, weekly changes of the Romanian government bond
yields between March 2019 and March 2022 (Figure 2) were used to derive principal
 J. Risk Financial Manag. 2022, 15, 247 13 of 37

components (PCs), via eigenvalue decomposition of the covariance matrix, as per the
methodology described in Section 3 of the present article. This period was chosen to
analyze how government market yields react in times of severe market stress, such as the
outbreak of the COVID-19 pandemic in March 2020 or the Russian military invasion in
Ukraine in February 2022. The patterns observed in our analysis are deeply rooted in the
particularities of the Romanian government bond market. For example, in the proximity of
extreme events, such as the aforementioned ones, Romanian government yields marked
increases of large magnitude, in bear-steepening movements. This was mainly due to the
10-year segment being particularly sensitive to such events, given that offshore holdings
are largely concentrated in the back-end zone of the yield curve (in times of severe market
distress, foreign investors tend to liquidate their holdings at a faster pace).
The period considered was marked not only by global turbulences but also by internal
pressures arising from fiscal imbalances, elevated twin deficits, and political uncertainty.
However, pessimistic prospects were counterbalanced by expectations of a resilient eco-
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 14 of 39
nomic growth and fiscal consolidation amid reforms undertaken within the Recovery and
Resilience Facility (RRF) plan12 and the Excessive Deficit Procedure (EDP).

7
6 6M
5 1Y
4 2Y
3 3Y
2
4Y
1
5Y
0
7Y
10Y

Figure 2. Romanian government bond yields between March 2019 and March 2022. Source: Bloomberg.
Figure 2. Romanian government bond yields between March 2019 and March 2022. Source: Bloom-
berg.
The raw data set consisted of closing midmarket yields from Bloomberg, correspond-
ing to the 6-month and 1-, 2-, 3-, 4-, 5-, 7-, and 10-year tenors. The covariance matrix was
The raw data set consisted of closing midmarket yields from Bloomberg, correspond-
computed from exponentially weighted observations13 in order to put more emphasis on
ing to the 6-month and 1-, 2-, 3-, 4-, 5-, 7-, and 10-year tenors. The covariance matrix was
recent market developments. Afterwards, the orthogonal factors were calculated from the
computed from exponentially weighted observations11 in order to put more emphasis on
covariance matrix of the weekly yield changes at different points in time.
recent market developments. Afterwards, the orthogonal factors were calculated from the
The loading for each factor represents the sensitivity of a particular variable to a one-
covariance matrix of the weekly yield changes at different points in time.
unit change in a specific factor (principal component). In the case of the example obtained
The loading for each factor represents the sensitivity of a particular variable to a one-
from our most recent data, on 25 March 2022 (Table 1, Figure 3), we can observe that if
unit change in a specific factor (principal component). In the case of the example obtained
the first principal component goes up by one unit, then the 2-year government market
from our most recent data, on 25 March 2022 (Table 1, Figure 3), we can observe that if the
yield will change by 0.32 basis points, the 5-year market yield will increase by 0.40 basis
first principal
points, and thecomponent goes
10-year rate willupincrease
by one by unit,
0.49then
basisthepoints
2-year(the
government
first column market
of theyield
factor
will change
loading by 0.32Inbasis
matrix). points, the
the second 5-yearthe
column, market
loadingsyield will
for theincrease
second by 0.40 basis
principal points,
component
and
arethe 10-year rate
displayed. willthere,
From increaseweby can0.49 basis that
notice points (the first
when column principal
the second of the factor loading
component
matrix). In the second column, the loadings for the second principal
increases by one unit, the short end of the yield curve will increase while the longer component are dis-
end
played. From there, we can notice that when the second principal component
will decrease, suggesting a flattening of the yield curve as the second principal component increases by
one unit, theEventually,
increases. short end of the yield
when curveprincipal
the third will increase while the
component longer end
increases, the will
verydecrease,
short and
suggesting a flattening
long end segments of of
thethe yield curve
sovereign curveas increase,
the second principal
while yields component
around the increases.
belly zone
Eventually, when the third
decrease. Additionally, weprincipal
observe that component
on 25 Marchincreases,
2022, the
the very short andcomponent
first principal long end
segments of the sovereign curve increase, while yields around the belly
(PC1) explains 80.83% of the yield curve changes, the first two 91.92%, and the first three zone decrease.
Additionally,
96.87%. These wefindings
observearethat on 25 March
consistent 2022, the works
with previous first principal
from thecomponent (PC1) state
literature, which ex-
plains 80.83% of the yield curve changes, the first two 91.92%, and the first
that the first three PCs generally explain around 95% of the variability in the term structure. three 96.87%.
These findings are consistent with previous works from the literature, which state that the
first three PCs generally explain around 95% of the variability in the term structure.

Table 1. Factor loadings, eigenvalues, and variances explained by principal components on 25 March
2022. Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by Le-
 J. Risk Financial Manag. 2022, 15, 247 14 of 37

Table 1. Factor loadings, eigenvalues, and variances explained by principal components on 25 March
2022. Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by
Leonardo Volpi.14

CumVar 80.83% 91.99% 96.87% 99.23% 99.72% 99.95% 99.98% 100.00%

Var 80.83% 11.16% 4.88% 2.36% 0.49% 0.23% 0.03% 0.02%
EigVal 3531.13 487.69 213.29 103.15 21.36 9.97 1.27 0.85
PC1 PC2 PC3 PC4 PC5 PC6 PC7 PC8
6M 0.1810 0.4069 0.7419 0.4945 0.0381 0.0115 0.0413 0.0583
1Y 0.1501 0.1756 0.4322 −0.8577 0.1513 0.0318 −0.0072 −0.0165
2Y 0.3210 0.3603 −0.3472 0.0666 0.6010 0.1689 −0.4461 0.2311
3Y 0.3243 0.4433 −0.3073 −0.0078 −0.0768 0.2143 0.5462 −0.5038
4Y 0.3465 0.2261 −0.1851 −0.0886 −0.4217 −0.3655 0.1984 0.6602
5Y 0.4008 −0.0038 −0.0061 0.0056 −0.3370 −0.4117 −0.5689 −0.4823
J. Risk Financial
7Y Manag.0.4674
2022, 15, x FOR−PEER REVIEW 0.0846
0.3811 0.0162 −0.3107 0.7073 −0.1139 15 of 39
0.1384
10Y 0.4871 −0.5300 0.0800 0.0848 0.4697 −0.3481 0.3536 −0.0392

Figure
Figure3.3.Yield
Yieldcurve
curvevariability
variabilityexplained
explainedbybyprincipal
principalcomponents
componentsonon25
25March
March2022.
2022.Source:
Source:
Bloomberg,
Bloomberg,ownowncomputation
computationofofPCs
PCswith
withthe
theuse
useof
ofaaVBA
VBAadd-in
add-indeveloped
developedby
byLeonardo
LeonardoVolpi.
Volpi.

Figure
Figure44depicts
depictswhat
whathashasbeen
beenstated
statedpreviously,
previously,thatthatthe
thefirst
firstprincipal
principalcomponent
component
(PC)
(PC) captures
captures mostmost level
levelshifts
shiftswithin
withinthethe yield
yield curve,
curve, whenwhen the entire
the entire term structure
term structure moves
moves in thedirection.
in the same same direction.
This canThis can correspond
correspond to arise
to a general general
or fallrise or forward
of all fall of allrates
forward
in the
rates
yieldincurve
the yield
(not curve (not necessarily
necessarily a parallel
a parallel shift!). Theshift!).
second ThePCsecond PC captures
captures the slope the slope
of the of
yield
the yield
curve curve
and, more and, more specifically,
specifically, situations situations
in whichin which
the shortthe
endshort
moves endinmoves in opposite
opposite direction
compared
direction with thewith
compared longtheendlong
zoneend(Moody’s Analytics
zone (Moody’s 2014). The
Analytics third
2014). ThePC captures
third PC cap-the
curvature
tures (butterfly)(butterfly)
the curvature of the sovereign yield curve,
of the sovereign when
yield thewhen
curve, shorttheandshort
longand
end long
segments
end
move up move
segments at the same
up at time as thetime
the same yields
ascorresponding to the belly zone
the yields corresponding to themove
bellydown, or vice
zone move
versa (Moody’s
down, or vice versa Analytics
(Moody’s 2014).
Analytics 2014).
Whenplotting
When plottingthe factorloadings,
thefactor loadings,their
theirinterpretation
interpretationbecomes
becomesclearer:
clearer:
Even though there are as many principal components as there are variables in the
original data, it was observed that in the case of interest rates, the first three principal
1
components generally explain most of the variance in the data. More factor loadings cor-
responding
0.8 to the fourth or fifth principal component can be plotted (Figure A1 from
Appendix A), but no specific economic interpretation has been assigned to them, nor have
they been
0.6 of particular interest for researchers throughout time.

0.4
PC1
0.2 PC2
PC3
 the yield curve and, more specifically, situations in which the short end moves in opposite
direction compared with the long end zone (Moody’s Analytics 2014). The third PC cap-
tures the curvature (butterfly) of the sovereign yield curve, when the short and long end
segments move up at the same time as the yields corresponding to the belly zone move
down,
J. Risk Financial Manag. 2022, 15, 247 or vice versa (Moody’s Analytics 2014). 15 of 37
When plotting the factor loadings, their interpretation becomes clearer:

0.8

0.6

0.4
PC1
0.2 PC2
PC3
0
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 16 of 39
6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
-0.2

-0.4Even though there are as many principal components as there are variables in the
original data, it was observed that in the case of interest rates, the first three principal
-0.6
components generally explain most of the variance in the data. More factor loadings corre-
sponding to the fourth or fifth principal component can be plotted (Figure A1 from Ap-
FigureFigure 4. Factor
4. Factor loadingstheoffirst
the three
first three principal components on March
25 March 2022. Source: Bloomberg,
pendix A),loadings
but noofspecific economicprincipal components
interpretation on 25
has been 2022.
assigned Source:
to them, Bloom-
nor have
own computation of PCs with the use of a VBA add-in developed
berg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi. by Leonardo Volpi.
they been of particular interest for researchers throughout time.
AsAsresearch
researchininthe thefield
fieldpointed
pointedout outthat
thatthethefirst
firstthree
threeprincipal
principalcomponents
componentstypically
typically
account
accountfor forabout
about95% 95%ofof thethetotal
totalvariance
variance in in
yield
yieldchanges,
changes,wewe conducted
conducted calculations
calculationsat
different
at differentmoments
moments to check
to check whether
whether thisthis
theory
theory also
alsoholds
holdsininthe
thecase
caseofofthe
theRomanian
Romanian
government
governmentbond bondmarket.
market.
Interestingly,
Interestingly, we we observed that that the
theexplanatory
explanatorypower powerofofthe thefirst
first principal
principal compo-
component
nent (the yield curve variance explained by the first PC) increases
(the yield curve variance explained by the first PC) increases significantly following extreme significantly following
extreme
market market
events. events.
Figure Figure
5 reveals 5 reveals
that onthat on 28 February
28 February 2020,
2020, the theprincipal
first first principal com-
component
ponent
explainedexplained only 70.52%
only 70.52% of thecurve
of the yield yield variability,
curve variability, the
the first first
two two principal
principal com-
components
90.35%, 90.35%,
ponents and the and first the
three 95.71%.
first The explanatory
three 95.71%. power ofpower
The explanatory PCs increased in the following
of PCs increased in the
week to 79.28%
following week tofor the first
79.28% forPC,the92.89%
first PC,for the first
92.89% fortwo
the and
first 96.43%
two andfor the first
96.43% forthree PCs
the first
(Figure 15 the first
three PCs6).(Figure
On 206). MarchOn 20 2020,
March 2020,13 PC the was
first already
PC was explaining 91.51% of91.51%
already explaining the yield
of
curve movements, the first two 98.87%, and the first three 99.62%
the yield curve movements, the first two 98.87%, and the first three 99.62% (Figure 7). This (Figure 7). This finding
suggests
finding that when
suggests that market
when marketmovementsmovements of suchofamplitude take place,
such amplitude they usually
take place, reflect
they usually
more ofmore
reflect a level
of ashift
levelinshift
interest rates (Ronn
in interest 1996, p.
rates (Ronn 14).p. 14).
1996,

Figure
Figure5.5.Yield
Yieldcurve
curvevariability
variabilityexplained
explainedby
byprincipal
principalcomponents
componentsonon2828February
February2020.
2020.Source:
Source:
Bloomberg,
Bloomberg, own computation of PCs with the use of a VBA add-in developed by LeonardoVolpi.
own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi.
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 17 of 39
J. J.Risk
RiskFinancial
FinancialManag.
Manag.2022,
2022,15,
15,x 247
FOR PEER REVIEW 1716ofof3937

Figure
Figure6.6.Yield
Yieldcurve
curvevariability
variabilityexplained
explainedbybyprincipal
principalcomponents
componentson on66March
March 2020.
2020. Source:
Source:
Figure 6. Yield curve variability explained by principal components on 6 March 2020. Source:
Bloomberg,
Bloomberg, own
owncomputation
computation ofofPCs
PCswith
withthe
theuse
useofofaaVBA
VBAadd-in
add-indeveloped
developedby
byLeonardo
Leonardo Volpi.
Volpi.
Bloomberg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi.

Figure 7. Yield curve variability explained by principal components on 20 March 2020. Source:
Figure 7. Yield curve variability explained by principal components on 20 March 2020. Source:
Figure 7. Yield
Bloomberg, owncurve variability
computation explained by use
principal components on 20 March 2020. Source:
Bloomberg, own computation ofofPCs
PCswith
withthe
theuse ofofaaVBA
VBA add-indeveloped
add-in developed byLeonardo
by Leonardo Volpi.
Volpi.
Bloomberg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi.
Our observations are consistent with those of Golub and Tilman (2000), in the sense
Our observations are consistent with those of Golub and Tilman (2000), in the sense
thatOur observations
interest are consistent
rate movements tend towith
becomethosemore
of Golub and Tilman
synchronized in a(2000),
severelyin the sense
distressed
that interest rate movements tend to become more synchronized in a severely distressed
market
that environment,
interest leadingtend
rate movements to higher correlations
to become between maturities
more synchronized (Golub distressed
in a severely and Tilman
market environment, leading to higher correlations between maturities (Golub and Til-
2000, p.environment,
market 103). We canleading
observetothat at thecorrelations
higher same time with the increase
between maturitiesin the first and
(Golub principal
Til-
man 2000, p. 103). We can observe that at the same time with the increase in the first prin-
component’s
man explanatory
2000, p. 103). power,that
We can observe yieldat correlations
the same time at with
the term structure
the increase inlevel increased
the first prin-
cipal component’s explanatory power, yield correlations at the term structure level in-
dramatically
cipal component’sin March 2020. For
explanatory example,
power, yieldwhile the correlation
correlations coefficient
at the term structurebetween the
level in-
creased dramatically
2-year and in Marchwas
the 10-year 2020. For example, while the(Table
correlation coefficient be-
creased dramatically in yields
March 2020. 0.51
Foronexample,
28 February
while2020 2), within
the correlation less than
coefficient be-a
tween
month, the 2-year and the 10-year yields was 0.51 on 28 February 2020 (Table 2), within less
tween theit2-year
reached 0.82
and the(Table 3).yields
10-year was 0.51 on 28 February 2020 (Table 2), within less
than a month, it reached 0.82 (Table 3).
than a month, it reached 0.82 (Table 3).
Table 2. Correlation matrix of Romanian weekly yield changes on 28 February 2020. Source: Bloom-
Table 2. Correlation matrix of Romanian weekly yield changes on 28 February 2020. Source: Bloom-
berg, own computation of the correlation matrix of yield changes.
berg, own computation of the correlation matrix of yield changes.
Corell. 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
Corell. 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
6M 1 0.445185 0.267383 0.271843 0.219032 0.252181 0.232288 0.263297
6M 1 0.445185 0.267383 0.271843 0.219032 0.252181 0.232288 0.263297
1Y 0.445185 1 0.372053 0.428519 0.277162 0.233198 0.235828 0.18192
1Y 0.445185 1 0.372053 0.428519 0.277162 0.233198 0.235828 0.18192
2Y 0.267383 0.372053 1 0.804901 0.61661 0.569723 0.560736 0.514846
2Y 0.267383 0.372053 1 0.804901 0.61661 0.569723 0.560736 0.514846
J. Risk Financial Manag. 2022, 15, 247 17 of 37

Table 2. Correlation matrix of Romanian weekly yield changes on 28 February 2020. Source:
Bloomberg, own computation of the correlation matrix of yield changes.

Corell. 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
6M 1 0.445185 0.267383 0.271843 0.219032 0.252181 0.232288 0.263297
1Y 0.445185 1 0.372053 0.428519 0.277162 0.233198 0.235828 0.18192
2Y 0.267383 0.372053 1 0.804901 0.61661 0.569723 0.560736 0.514846
3Y 0.271843 0.428519 0.804901 1 0.863154 0.784579 0.800367 0.779038
4Y 0.219032 0.277162 0.61661 0.863154 1 0.894921 0.916332 0.891449
5Y 0.252181 0.233198 0.569723 0.784579 0.894921 1 0.886539 0.899717
7Y 0.232288 0.235828 0.560736 0.800367 0.916332 0.886539 1 0.960033
10Y 0.263297 0.18192 0.514846 0.779038 0.891449 0.899717 0.960033 1

Table 3. Correlation matrix of Romanian weekly yield changes on 20 March 2020. Source: Bloomberg,
own computation of the correlation matrix of yield changes.

Corell. 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
6M 1 0.372496 0.63688 0.617435 0.567352 0.628632 0.547862 0.568978
1Y 0.372496 1 0.394008 0.499355 0.504074 0.318997 0.512123 0.481065
2Y 0.63688 0.394008 1 0.944869 0.868314 0.902138 0.817978 0.824703
3Y 0.617435 0.499355 0.944869 1 0.949967 0.91885 0.916332 0.925064
4Y 0.567352 0.504074 0.868314 0.949967 1 0.920361 0.971006 0.966721
5Y 0.628632 0.318997 0.902138 0.91885 0.920361 1 0.898622 0.909081
7Y 0.547862 0.512123 0.817978 0.916332 0.971006 0.898622 1 0.987694
10Y 0.568978 0.481065 0.824703 0.925064 0.966721 0.909081 0.987694 1

5.2. Steepeners and Flatteners of the Romanian Sovereign Yield Curve: The Use of PCA in
Identifying Relative-Value Trading Opportunities
So far, we have been addressing the subject of principal components’ explanatory pow-
ers and how they change depending on market conditions. However, principal components’
coefficients (factor loadings or eigenvectors), as well as principal components themselves
(scores or eigenvalues), also provide valuable information on the pattern of yield changes.
For instance, returning to the example from Table 1, we can observe that the factor
loadings corresponding to the 2-year maturity are lower than those corresponding to the
10-year maturity, suggesting that in the case of a market sell-off, yields at 10 years will
increase more than those at 2 years, leading to a steepening of the yield curve. Similarly, in
situations of market rallies, long-term interest rates will decrease less than short-term ones,
resulting in a flattening pattern.
An additional experiment16 was performed to investigate whether actual patterns
observed in the market support these theoretical findings. Weekly changes in the level
and slope of the Romanian sovereign yield curve were considered. Afterwards, data were
categorized such that the market was considered bull if the 10-year yield decreased by more
than 5 basis points in a week, bear if it increased by more than 5 basis points, and neutral
otherwise. Similarly, a change in the slope of the yield curve was categorized as a steepening
if the spread between the 2- and the 10-year interest rates increased by more than 5 basis
points, flattening if it decreased by more than 5 basis points, and unchanged otherwise.
Over the 2-year period spreading from 20 March 2020 to 25 March 2022 (Figure 8), the
ratio of bull flattenings to bull steepenings of the Romanian sovereign yield curve was 20 to
0, and the ratio of bear steepenings to bear flattenings was 4.6 to 1. Bull flattening and bear
steepening patterns also seemed to dominate the period before the COVID-19 pandemic
(Figure 9). However, the proportions were different: the ratio of bull flattenings to bull
steepenings was 5.5 to 1, and the ratio of bear steepenings to bear flattenings was 4 to 1. The
patterns that emerged in the last 52 trading weeks before 25 March 2022 are also available
in Figure A2 from Appendix A.
The conclusions of the experiment are consistent with what the factor loadings of the first
principal component revealed, that in the case of market sell-offs, yields at 10 years increase
J. J.
J. Risk
Risk
Risk Financial Manag.
FinancialManag.
Financial 2022,
Manag.2022, 15,
2022,15, xx FOR
15,247 FOR PEER
PEER REVIEW
REVIEW 19
19 of
of 39
39
18 of 37

rallies,
more thanlong-term
those interest ratesleading
at 2 years, decreasetoless than
yield short-term
curve ones, resulting
steepenings, while ininmarket
flattening
rallies,
patterns.
long-term interest rates decrease less than short-term ones, resulting in flattening patterns.

Figure
Figure 8.
Figure 8. Weekly
8. Weekly yield
Weekly yield curve
yield curvepatterns
curve patternsbetween
patterns between20
between 20March
20 March2020
March 2020and
2020 and25
and 25March
25 March2022.
March 2022.Source:
2022. Source:Bloom-
Source: Bloom-
Bloomberg
berg
berg yields,
yields, own
own computation
computation of
of yield
yield curve
curve patterns.
patterns.
yields, own computation of yield curve patterns.

Figure 9. Weekly yield curve patterns on 28 February 2020 (last 52 weeks). Source: Bloomberg yields,
own computation of yield curve patterns.
 J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 20 of 39

Figure 9. Weekly yield curve patterns on 28 February 2020 (last 52 weeks). Source: Bloomberg yields,
own computation of yield curve patterns.
J. Risk Financial Manag. 2022, 15, 247 19 of 37

The patterns observed in our analysis are deeply rooted in the characteristics of the
Romanian government bond market, where they find logical explanations. For example,
in the
The patterns immediate
observed in proximity
our analysisof extreme events
are deeply (such in
rooted as the
the characteristics
start of the Russian military
of the
Romanian government bond market, where they find logical explanations. For example,yields
invasion in Ukraine or the start of the COVID-19 pandemic), Romanian government
marked
in the immediate increasesofofextreme
proximity large magnitude, in bear-steepening
events (such as the startmovements (Figures
of the Russian 10 and 11).
military
This is mainly due to the fact that the 10-year segment is particularly sensitive to such
invasion in Ukraine or the start of the COVID-19 pandemic), Romanian government yields
stressful events, given the offshore share that remains concentrated in the back-end zone
marked increases of large magnitude, in bear-steepening movements (Figures 10 and 11). This
of the yield curve.15 However, part of the steepening pattern tends to reverse in the weeks
is mainly due following
to the factsuch
thatshocks,
the 10-year
as somesegment is particularly
bull-flattening movements sensitive
emergetoinsuch stressful
the form of market
events, given the offshore share that remains concentrated in the back-end zone of the yield
corrections.
curve.17 However, part of the steepening pattern tends to reverse in the weeks following
such shocks, as some bull-flattening movements emerge in the form of market corrections.

J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 21 of 39

Figure
Figure 10. Weekly 10.curve
yield Weekly yield curve
patterns patterns
on 20 Marchon2020
20 March
(last 42020 (last 4Source:
weeks). weeks). Bloomberg
Source: Bloomberg
yields,yields,
own computation of yield curve patterns.
own computation of yield curve patterns.

Figure
Figure 11. Weekly yield11. Weekly
curve yield curve
patterns on 25patterns
March on 25 March
2022 (last 5 2022 (last Source:
weeks). 5 weeks).Bloomberg
Source: Bloomberg
yields, yields,
own computation of yield curve patterns.
own computation of yield curve patterns.
In March 2020, two major risks were weighing on the Romanian economy and, im-
plicitly, on the government debt market: on the one hand, the government ordinance for
organizing snap elections was declared unconstitutional16 by the Constitutional Court. On
the other hand, the local event coincided with the severe stress that the COVID-19 pan-
demic was determining on the global markets, which caused the long-term RON yields to
J. Risk Financial Manag. 2022, 15, 247 20 of 37

In March 2020, two major risks were weighing on the Romanian economy and, im-
plicitly, on the government debt market: on the one hand, the government ordinance for
organizing snap elections was declared unconstitutional18 by the Constitutional Court.
On the other hand, the local event coincided with the severe stress that the COVID-19
pandemic was determining on the global markets, which caused the long-term RON yields
to rise sharply.
On 20 March, the National Bank of Romania (NBR) joined the global monetary easing
policy measures adopted by most central banks in an extraordinary meeting. Among the
decisions adopted by the central bank was the cut of the key rate by 50 basis points to 2.00%
and the narrowing of the standing facilities corridor from ±100 basis points to ±50 basis
points. In addition, the NBR decided to provide liquidity to credit institutions via repo
transactions, in order to facilitate the smooth functioning of the money market, and to
purchase Romanian government bonds from the secondary market to consolidate liquidity
in the banking system. As such, following a short period of severe stress, marked by an
increase in the 10-year yield towards the 6% level, the Romanian government bonds finally
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 22 of 39
benefitted from the support provided by the NBR. By the end of March 2020, the 10-year
interest rate fell near the 4.5% level. However, the yield curve remained steeper than before
the sell-off, and the 10y–1y ROMGB spread was around 150 basis points, compared with
Eastern European
an average of 100 (CEE) countries
basis points and especially from
in January—February 2020Romania to historical
(Erste Group Research highs, in a
2020).
bear steepening pattern (Figure 11 from the present chapter and Figure A2 from
Throughout the year 2021, the Romanian yield curve continued to bear-steepen (Figure 12), Appendix
A). In light
as the of the yields
back-end aforementioned
followed coreevents, on 8inflation
market March 2022, the National
repricing, Bank
while the of Romania
front-end zone
returned to domestic
was, to some sovereign debt
extent, supported by thebuying, with
liquidity the scope
surplus fromoftheproviding
domesticliquidity to the
money market
banking system,
(Erste Group and prevented
Research it from in
2021). Moreover, becoming scarce
April 2021, in times
the NBR of sell-offs
stopped buyingcaused
Romanian by
severely
governmentstressful
bonds,events.
and inThis
theled to a flattening
August meeting, it ofannounced
the yield curve
the endandoftothe
thebond-buying
outperfor-
program,
mance leaving the
of ROMGBs ROMGBswith
compared more vulnerable
peers to the since
in the region impact theofstart
the global sell-off.
of the war in Ukraine.

Figure
Figure12.
12.Weekly
Weeklyyield
yieldcurve
curvepatterns
patternsinin2021.
2021.Source:
Source:Bloomberg
Bloombergyields,
yields,own
owncomputation
computationofofyield
yield
curve patterns.
curve patterns.

Market movements of large amplitudes—such as the ones triggered by intense risk-

off or risk-on sentiments—not only determine yield curve reshaping, but can also launch
assets into oversold or overbought territories. In the case of fixed income instruments, the
oversold or overbought conditions can emerge at the level of the yield curve as a whole,
or only at specific maturities, causing the term structure of interest rates to become “too
J. Risk Financial Manag. 2022, 15, 247 21 of 37

The Russian invasion of Ukraine at the end of February 2022 reshaped the course
of events once again. A sell-off driven by a risk-off sentiment, combined with rising
commodity prices and hence rising inflation expectations, propelled yields from the Central
Eastern European (CEE) countries and especially from Romania to historical highs, in a bear
steepening pattern (Figure 11 from the present chapter and Figure A2 from Appendix A). In
light of the aforementioned events, on 8 March 2022, the National Bank of Romania returned
to domestic sovereign debt buying, with the scope of providing liquidity to the banking
system, and prevented it from becoming scarce in times of sell-offs caused by severely
stressful events. This led to a flattening of the yield curve and to the outperformance of
ROMGBs compared with peers in the region since the start of the war in Ukraine.
Market movements of large amplitudes—such as the ones triggered by intense risk-off
or risk-on sentiments—not only determine yield curve reshaping, but can also launch
assets into oversold or overbought territories. In the case of fixed income instruments, the
oversold or overbought conditions can emerge at the level of the yield curve as a whole, or
only at specific maturities, causing the term structure of interest rates to become “too flat”
or “too steep”.
Apart from being a widely known technique used to reduce data complexity, PCA can
also be deployed in the identification of relative-value trading opportunities. For example,
it can highlight a segment of the yield curve that is too rich or too cheap, in which the
relative valuation is independent of the market direction (Credit Suisse Securities Research
and Analytics 2012, p. 3). This can be performed throughout the computation of residual
values as the difference between actually observed market yields and reconstructed data
(principal components). Thus, for each date and variable, a residual can be calculated
as below:
residualsij = dataij − reconstructedij (31)
with i = 1:8 (8 tenors considered) and j = 1:192 (192 weekly observations).
For the calculation of the reconstructed data, we recall that each principal component is a
linear combination of the original data and the factor loadings. For example, on 18 March 2022,
the vector of actual weekly yield changes (in basis points) for the tenors [6M; 1Y; 2Y; 3Y; 4Y; 5Y;
7Y; 10Y] was [−2; −2; −13.15; −6.67; −14.38; −26.45; −37.72; −49.27], and the loadings for
the first principal component were [0.18; 0.15; 0.32; 0.32; 0.35; 0.40; 0.47; 0.49] T . Therefore,
on that particular date, the value of the first PC was [−2 × 0.18; −2 × 0.15; −13.15 × 0.32;
−6.67 × 0.32; −14.38 × 0.35; −26.45 × 0.40; −37.72 × 0.47; −49.27 × 0.49] = −64.26. Analo-
gously, the value of the second principal component was also −64.26, while the value of the
third PC equaled −0.02. Therefore, given the negative realizations of PC1 and PC2 and almost
no effect from PC3, we can conclude that on that date, the yield curve bull-flattened.
By multiplying each principal component considered (the first three in our case) by
their corresponding factor loading, we were able to derive the reconstructed weekly yield
changes for each tenor [−37.82; −20.95; −43.77; −49.31; −36.79; −25.51; −5.55; 2.75] and,
implicitly, the reconstructed yields.
The most interesting step of this process was the analysis of residuals, as potential rich–
cheap trading signals. For instance, in the aforementioned example, we can observe that the
PCA-reconstructed yield changes for the 2- and 10-year yields were −44 and 2.75 basis points,
respectively, while the actual market changes were −13 and −49 basis points, respectively. The
residuals for the 2- and 10-year tenors were thus 31 basis points (=−13–(−44)) and −52 basis
points, respectively (=−49–2.75), suggesting that the yield curve might have turned too flat
following such strong decrease in the level of the 10-year yield. Interestingly, in the following
week, the yield movements corrected for those residuals’ mismatches, as the 2-year interest
rate increased by 11 basis points, while the 10-year rate increased by 40 basis points.
Another occasion where PCA-reconstructed data were revealing a “too flat” yield
curve was on 17 December 2021. While residuals for the same 2- and 10-year maturities
were 27.4 and −35 basis points, respectively, even though for the following 2 weeks there
were no significant movements registered on the Romanian domestic bond market, on the
third week since the mismatch discovery, both the 2- and 10-year yields increased by 13 and
 matches, as the 2-year interest rate increased by 11 basis points, while the 10-year rate
increased by 40 basis points.
Another occasion where PCA-reconstructed data were revealing a “too flat” yield
curve was on 17 December 2021. While residuals for the same 2- and 10-year maturities
J. Risk Financial Manag. 2022, 15, 247 were 27.4 and −35 basis points, respectively, even though for the following 2 weeks22there
of 37
were no significant movements registered on the Romanian domestic bond market, on the
third week since the mismatch discovery, both the 2- and 10-year yields increased by 13
and
30 30 basis
basis points,
points, respectively.
respectively. Similar
Similar situations
situations followed
followed by bull-steepening
by bull-steepening patterns
patterns were
were observed on 17 September 21 and 22 October 2021
observed on 17 September 21 and 22 October 2021 (Figure 13). (Figure 13).

50
40
30
20 18-Mar-22
10 17-Dec-21

0
17-Sep-21
-10 22-Oct-21

-20
-30

-50 -40

-70 -60
Residuals 2Y Residuals 5Y Residuals 10Y
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 24 of 39
Figure 13.PCA
Figure13. PCAresiduals
residuals(in
(inbasis
basispoints)
points)signaling “too
signaling flat”
“too yield
flat” curves.
yield Source:
curves. Own
Source: computation
Own computa-
tion
of of PCA
PCA residuals.
residuals.

OnOnthethe other
other side,side,
PCAPCA residuals
residuals signaling
signaling “too or
“too steep” steep” or “too expensive”
“too expensive” yield
yield curves
curves
(Figure (Figure
14) 14) were generally
were generally followed
followed by by bull-flattening
bull-flattening corrections.
corrections.

40 40

30 30

20 20

10 10
11-Mar-22
0 0 25-Feb-22

-10 -10 4-Mar-22

-20 -20

-30 -30

-40 -40
Residuals 2Y Residuals 5Y Residuals 10Y
Figure PCA
14.14.
Figure PCAresiduals (in (in
residuals basis points)
basis signaling
points) “too“too
signaling steep” yield
steep” curves.
yield Source:
curves. Own
Source: computa-
Own compu-
tion of PCA
tation residuals.
of PCA residuals.

Not
Notonly
only slope
thethe of the
slope of yield curvecurve
the yield but also
butthe curvature
also can be can
the curvature traded
be via PCA-based
traded via PCA-
residuals. For instance, if the residual corresponding to the belly zone of the yield curve
based residuals. For instance, if the residual corresponding to the belly zone of the yield is
very positive/negative
curve on a certain
is very positive/negative ondate, whiledate,
a certain the residuals
while thecorresponding to the “wings”
residuals corresponding to the
are“wings”
negative/positive, then a relative-value trader might consider entering
are negative/positive, then a relative-value trader might consider a short-term
entering a
short-term butterfly position (Credit Suisse Securities Research and Analytics 2012, p. 3)
(pay wings, receive bell, or vice versa).

5.3. Developing Romanian PCA Yield Curve Scenarios: Examples from the Outbreak of the
J. Risk Financial Manag. 2022, 15, 247 23 of 37

butterfly position (Credit Suisse Securities Research and Analytics 2012, p. 3) (pay wings,
receive bell, or vice versa).

5.3. Developing Romanian PCA Yield Curve Scenarios: Examples from the Outbreak of the
COVID-19 Pandemic and the Start of the Russian–Ukrainian War
5.3.1. Plausibility Measures of Interest Rate Shocks for Romanian Government Bonds
One of the major applications of principal component analysis (PCA) in finance is
that it provides valuable insights into both historical and hypothetical market movements,
while enabling the concept of historical plausibility (Golub and Tilman 2000, p. 231).
The general practice in scenario analysis is to investigate the price sensitivity of fixed
income instruments or portfolios to deterministic interest rate shocks without assessing their
historical likelihood. Practitioners often employ scenario analysis to determine whether
they represent acceptable interest rate exposures. In addition, they might consider a couple
of extreme shocks to check whether their portfolios would face unacceptable losses under
the circumstances of a crisis or severe market event. Incorporating the concept of likelihood
into a scenario analysis would improve its outcome in the sense that it would not only help
the portfolio manager to assess the large losses generated by extreme market events, but
also associate a probability estimation for that event to occur.
Given that principal component shocks are formulated in terms of standard devia-
tions (not basis points), it enables the principal component scenario analysis to be defined
in a probabilistic setting (Golub and Tilman 2000, p. 211). Afterwards, a transforma-
tion into basis points might be needed, given that yield curve shocks measured in basis
points are what portfolio managers are most accustomed to. This can be performed via
Equations (14) and (15) from Section 4 of the present article.
Returning to our most recent example from 25 March 2022, we were able to construct
the weekly principal components’ yield curve shocks in basis points corresponding to
one-standard-deviation changes in PCs (Table 4 and Figure 15):

Table 4. One-standard-deviation PCA weekly yield curve shocks and corresponding explanatory
powers on 25 March 2022.

Contribution
Weekly Shocks (bps) 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y Realization
(Explanatory Power)
PC1 shock 11 9 19 19 21 24 28 29 59.42 80.83%
PC2 shock 9 4 8 10 5 0 −8 −12 22.08 11.16%
PC3 shock 11 6 −5 −4 −3 0 1 1 14.60 4.88%
Parallel Shock 20 20 20 20 20 20 20 20 56.60 73.33%
YC First 3 PCAs Shock 31 19 22 23 24 21 18 31 96.87%
Source: Own computation.

Figure 16 and Table A1 from Appendix A display the corresponding annualized shock.
In addition, another shock that is said to be of the same shape as the first one, and which
corresponds to two-standard-deviation changes in the level of PCs, can be consulted in
Table A2 from Appendix A.
The contribution of each principal component in explaining the variability of the yield
curve dynamics (the explanatory power of a PC) is a measure of how representative a shock
is of the recent term structure dynamics. As such, among all interest rate shocks, the first
PC has, by construction, the highest explanatory power. The explanatory power of principal
components and, implicitly, of interest rate shocks is the simplest measure of historical
plausibility. For instance, on 25 March 2022, the first principal component explained 80.83%
of the Romanian yield curve variability, while the parallel shock explained 73.33%.
 YC First 3 PCAs Shock 31 19 22 23 24 21 18 31 96.87%
Source: Own computation.

Figure 16 and Table A1 from Appendix A display the corresponding annualized

shock. In addition, another shock that is said to be of the same shape as the first one, and
J. Risk Financial Manag. 2022, 15, 247
which corresponds to two-standard-deviation changes in the level of PCs, can be24 con- of 37

sulted in Table A2 from Appendix A.

J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 26 of 39

Figure 15. One-standard-deviation
Figure One-standard-deviationweekly yield
weekly curve
yield shocks
curve corresponding
shocks to each
corresponding principal
to each com-
principal
ponent on 25
component onMarch 2022.
25 March Source:
2022. Bloomberg
Source: yields,
Bloomberg ownown
yields, computation.
computation.

Figure
Figure16. One-standard-deviationannualized
16.One-standard-deviation annualizedyield
yieldcurve
curveshocks
shocksofofthe
thesame
sameshape
shapecorresponding
corresponding
totothe
thefirst
firstthree
threeprincipal
principalcomponents
componentscombined,
combined,on
on25
25March
March2022.
2022.Source:
Source:Bloomberg
Bloombergyields,
yields,own
own
computation.
computation.

The contribution
We computed the of
oneeach principal
standard component
deviation in explaining
corresponding the variability
to a parallel yield curveofshock
the
yield
as in curve
(Golubdynamics (the 2000,
and Tilman explanatory
p. 113).power of a PC)the
Afterwards, is ahistorical
measure likelihood
of how representative
of various
aparallel
shock ismovements could
of the recent termbestructure
assesseddynamics.
as, for example,
As such, theamong
weeklyall
parallel increase
interest in the
rate shocks,
the first PC has, by construction, the highest explanatory power. The explanatory powerrisk
level of yields of 50 basis points. As such, assuming that the whole range of systematic of
factors is components
principal represented by eight
and, key interest
implicitly, rates as rate
of interest displayed
shocksinisTable 4, a yield measure
the simplest curve shock
of
can be formulated
historical as follows:
plausibility. For instance, on 25 March 2022, the first principal component ex-
plained 80.83% of the Romanian yieldzcurve = (50,variability,
. . . 50)KR while the parallel shock explained (32)
73.33%.As such, the yield curve shock of unit length that has the same shape as z is given by:
We computed the one standard deviation corresponding to a parallel yield curve
shock as in Golub and Tilman (2000) (Golub 1and Tilman 1 2000, p. 113). Afterwards, the
 
) = √ , . .could
(ξ , . . . , ξ 10movements
historical likelihood of various1parallel
., √ (33)
8 8 beKR
assessed as, for example, the
weekly parallel increase in the level of yields of 50 basis points. As such, assuming that
the whole range of systematic risk factors is represented by eight key interest rates as dis-
played in Table 4, a yield curve shock can be formulated as follows:

𝑧 = (50, … 50) (32)

As such, the yield curve shock of unit length that has the same shape as 𝑧 is given by:

1 1
( ) (33)
J. Risk Financial Manag. 2022, 15, 247 25 of 37

By using the covariance and correlation matrices along with Equation (19) from
Section 3 of the current paper, it can be shown that:

σ(ξ ) = (ξ 1 , . . . , ξ 8 )Σ(ξ 1 , . . . , ξ 8 ) T = 57 (34)

and thus, one standard deviation of a parallel yield curve shock on 25 March 2022 is
57 √1 = 20 basis points per week (Table 5).
8
Analogous to Equation (22) from Section 4.1 of this article, a 50-basis-point parallel
increase of the term structure can be written as follows:
   
50 20 √  
20
 
20
8 50
z = . . . = . . . 50 = . . . = . . . 2.5 (35)
57 57
50 20 20 20

Equation (35) reveals that on 25 March 2022, the weekly 50-basis-point parallel yield
curve shift corresponded to a 2.5 standard deviation realization of the underlying standard
normal variable. Using a table of cumulative normal distributions, we find that on 25 March
2022, the probability of government yields increasing by 50 basis points over the course of
1 week was 0.62% (Table 5). Similarly, the probability associated with a weekly 30-basis-point
increase was 6.68% (corresponding to a 1.5 standard deviation) and so on. The annualized
parallel shocks can also be computed as well (Table A2 from Appendix A).
Additionally, we computed the probabilities of yield curve shocks based on PCA,
along with their corresponding standard deviations, for a series of dates characterized by
severe market turbulences due to events such as the outbreak of the COVID-19 pandemic
in March 2020 or the start of the war in Ukraine on 24 February 2022.(Table A3 from
Appendix A) We observe that on 28 February 2020, the likelihood associated with a weekly
25 basis points increase in the level of yields was 0.16% (Table 6). On 13 March 2020, the
probability corresponding to the same event was already higher than 15.8% (Table 7).
Two years later, on 18 February 2022, the likelihood of a weekly 25 basis points increase
across the yield curve was only 0.24% (Table 8) and it raised to roughly 2.28% on 25 February
(Table 9), after the strike of the Russian war in Ukraine. Similarly, the probability associated
with a weekly 15-basis-point increase rose from 4.55% on 18 February 2022 to 10.56% on
25 February 2022.

Table 5. Likelihood of principal components’ weekly yield curve shocks on 25 March 2022.

Corresponding Standard
YC Weekly Shock (bps.) Likelihood
Deviation
10 0.50 30.85%
20 1.00 15.87%
25 1.25 10.56%
30 1.50 6.68%
40 2.00 2.28%
50 2.50 0.62%
60 3.00 0.13%
Source: Bloomberg yields, own computation

Table 6. Likelihood of principal components’ weekly yield curve shocks on 28 February 2020.

YC Weekly Shock (bps.) Corresp. STDEV Likelihood

5 0.59 28.76%
8 1.00 15.87%
15 1.77 3.84%
20 2.36 0.91%
25 2.95 0.16%
Source: Bloomberg yields, own computation.
J. Risk Financial Manag. 2022, 15, 247 26 of 37

Table 7. Likelihood of principal components’ weekly yield curve shocks on 13 March 2020.

YC Weekly Shock (bps.) Corresp. STDEV Likelihood

17 0.50 30.85%
34 1.00 15.87%
43 1.25 10.56%
51 1.50 6.68%
68 2.00 2.28%
85 2.50 0.62%
102 3.00 0.13%
Source: Bloomberg yields, own computation.

Table 8. Likelihood of principal components’ weekly yield curve shocks on 18 February 2022.

YC Weekly Shock (bps.) Corresp. STDEV Likelihood

5 0.56 28.77%
9 1.00 15.87%
15 1.69 4.55%
20 2.25 1.22%
25 2.82 0.24%
Source: Bloomberg yields, own computation

Table 9. Likelihood of principal components’ weekly yield curve shocks on 25 February 2022.

YC Weekly Shock (bps.) Corresp. STDEV Historical likelihood

6 0.50 30.85%
12 1.00 15.87%
15 1.25 10.56%
18 1.50 6.68%
24 2.00 2.28%
30 2.50 0.62%
36 3.00 0.13%
Source: Bloomberg yields, own computation.

Magnitude plausibility (mpl) represents the second historical plausibility measure of

yield curve scenarios based on PCA. By applying Equation (23) from Section 4.2 of the
present article to our examples from the Romanian government bond market, we can assess
whether the magnitudes of specific registered market movements could be considered
plausible from a historical perspective.
For instance, in the example from 25 March 2022 (Equations (36) and (37) and Table 5),
the magnitude plausibility of a weekly 50-basis-point shift (in either direction) was 1.24%.

(50, . . . 50)KR ↔ S = 2.5 (36)

mpl (z) = P(N(0, 1) ≤ −2.5 or N(0, 1) ≥ 2.5) = 1.24% (37)

Analogously, on that date, the magnitude plausibility of a weekly 40- and 30-basis-point
shift (in either direction) was 4.56% and 13.36%, respectively.
Moving to the probabilistic framework of weekly yield curve scenarios during the
outbreak of the COVID-19 pandemic, we found that on 13 March 2020, the magnitude
plausibility of a weekly 102-basis-point shift (in either direction) was 0.26% (corresponding to
a three standard deviation). This result suggests that the amplitude of market movements
registered in that particular week (up to 80–100 basis point increases across the yield curve)
was highly improbable from a historical perspective.
Eventually, shape plausibility represents a more fine-tuning measure of historical plau-
sibility. Recall from Section 4.2 that the decomposition of the most representative yield
curve shock is given by (θ M,1 , . . . , θ M,n ) = (ζ 1 , . . . , ζ n ), where each principal component’s
J. Risk Financial Manag. 2022, 15, 247 27 of 37

contribution (θ M,i ) to this shock is the same as its explanatory power (ζ i ). In our case, on
25 March 2022, the decomposition of the most representative interest rate shock is:

(θ M,1 , . . . , θ M,n ) = (ζ 1 , . . . , ζ n ) = (80.83, 11.16, 4.88, . . . , 0.02) (38)

and the least representative one is always given by:

(θ L,1 , . . . , θ L,n ) = (0, . . . , 0, 100). (39)

Between the most and the least representative shocks, the shape plausibility spl (z)
will take a value between 0% and 100% that can be assigned to a certain interest rate shock
spl: z → x є [0%, 100%].
Under these hypotheses and with the use of Equations (27) and (28) from Section 4.1
of the present paper, we were able to compute the shape plausibility of interest rate shocks
at different points in time. We computed the shape plausibility (spl) of actual yield changes
from 13 March 2020 and 25 February 2022 and discovered that the likelihood of the first
shape was high, 98.15% (Table A4 from Appendix A). Combining this result with the above
observations, we conclude that during the outbreak of the COVID-19 pandemic, both
explanatory power and shape plausibility were characteristic of the yield curve dynamics and,
from this angle, historically plausible. However, the magnitude of the increases in the level
of interest rates was unusually large from the historical perspective. As regards the interest
rate changes registered on 25 March 2022, apart from being historically too large, they were
also unusually steeper judging by recent market developments, with a shape plausibility of
only around 70%.

5.3.2. Incorporating Trader’s View to Derive Romanian PCA Yield Curve Forecasts
Besides the results obtained from financial modelling, when deriving yield curve
forecasts, traders and portfolio managers often incorporate a significant amount of expert
judgment and intuition based on market experience. PCA is particularly useful in this
case if, for example, we have a view on a specific point on the yield curve and we might
probably demand to know what the rest of the term structure would look like if our view
turns to be correct. As we have stated previously in this article, Nogueira (2008) assumes
that a portfolio manager or trader is able to provide a view of a few benchmark yields or a
combination of yields and then derive a forecast of the entire yield curve.
Since the vast majority of term structure variability can typically be attributed to
one or two principal components (Golub and Tilman 2000, p. 237), having a view on
one or two relatively distanced tenors should be enough to derive a forecast of the entire
term structure.
For example, suppose we have two views on the 2- and 5-year yields of the Romanian
sovereign curve and we need to update the rest of the yield curve points to fit our two-
view expectations. To do this, we impose that the shape of the yield curve is consistent
with the main principal components, and implement the theorem developed by Nogueira
(Equations (31) and (32) from Section 3 of the present paper). Since the trader only has
two views, according to Nogueira’s theorem, all movements expressed in the views are
explained by the first two principal components alone.
First, we considered the example from 18 February 2022, a date that coincided with
the week before the concretization of the Russian military invasion in Ukraine. In this case,
we considered that the trader had the following two views on the yield curve:
i. The Romanian 2-year yield to increase from 4.48% to 4.62%;
ii. The Romanian 5-year yield to increase from 5.12% to 5.38%;
Given the example above, we will first display an argument interpretation of Nogueira’s
formulas:
E[yt+1 ] represents our derived forecast for the yield curve, which incorporates the
expectations for the 2- and 5-year interest rates.
J. Risk Financial Manag. 2022, 15, 247 28 of 37

yt is the current yield curve corresponding to six benchmark maturities (2, 3, 4, 5, 7,

and 10 years) such that vector ytT = (y2Y 3Y 4y 5y 7y 10y
t yt yt yt yt yt ).
D represents a matrix of standard deviations of each yield curve tenor.
∆q is an nx1 matrix of expected changes for the two particular tenors  thatwe had
4.62%
a view on, meaning the 2-year and the 5-year yield; in our case, qt+1 = in our
5.38%
 
0.14
∆q = .
0.27
We is the eigenvalue matrix associated with the principal components. In this case,
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 30 of 39
a subsection mxn matrix is taken from the original mxm PCA matrix, where n represents
the number of principal components included in the forecast; in the case of our two-view
example, that would be a 6 × 2 matrix of PCA eigenvalues.
Lastly,
Lastly, VVisisanannxm
nxmdummy
dummymatrix,
matrix,which
whichtakes
takesthe
thevalue
value1 1for
forany
anytenor
tenorthat
thatwe
wehave
have
1 0 0 0 0 0
a view on and 0 otherwise; in our case, V = 1( 0 0 0 0 ).0
a view on and 0 otherwise; in our case, V = ( 0 0 0 1 0 0 ).
0 0 0 and
Afterwards, we perform matrix multiplication 1 inverse
0 0 function to derive the ex-
Afterwards, we perform matrix multiplication and inverse function to derive the
pected movement for every yield curve tenor. It is important to mention here that the
expected movement for every yield curve tenor. It is important to mention here that the
views in our example, as in the case of Nogueira (2008), were deliberately chosen to match
views in our example, as in the case of Nogueira (2008), were deliberately chosen to match
the realized yields (Nogueira 2008, p. 7) for the 2- and 5-year tenors, registered 1 week
the realized yields (Nogueira 2008, p. 7) for the 2- and 5-year tenors, registered 1 week later,
later, on 25 February 2022. The choice of this date was not coincidental, as it represented
on 25 February 2022. The choice of this date was not coincidental, as it represented the first
the first day following the Russian invasion of Ukraine, with a significant impact on the
day following the Russian invasion of Ukraine, with a significant impact on the sovereign
sovereign debt costs of all peers in the CEE region.
debt costs of all peers in the CEE region.
The same procedure was repeated for the case of a single view on the yield curve,
The same procedure was repeated for the case of a single view on the yield curve, that
that is, the 2-year yield.
is, the 2-year yield.
Table 10 and Figure 17 display the current market yields on 18 February 2022, their
Table 10 and Figure 17 display the current market yields on 18 February 2022, their
forecasts (withthe
forecasts (with theone-
one-and
andtwo-tenor-view
two-tenor-viewapproach),
approach),and andthe
theactually
actuallyrealized
realizedmarket
market
yields on 25 February
yields on 25 February 2022. 2022.

6.2

5.8

5.6

5.4
Yields on 18 February 2022
5.2
Expected yields at 1 week (1
5 View)
Expected yields at 1 week (2
4.8
views)
4.6 Realized yields on 25 February
2022
4.4
2Y 3Y 4Y 5Y 7Y 10Y

Figure 17. Weekly yield curve forecasts incorporating the trader’s views on 18 February 2022 and
Figure 17. Weekly yield curve forecasts incorporating the trader’s views on 18 February 2022 and
realized yields on 25 February 2022. Source: Bloomberg, own computation.
realized yields on 25 February 2022. Source: Bloomberg, own computation.

Table 10. Weekly yield curve forecasts incorporating the trader’s views on 18 February 2022 and
realized yields on 25 February 2022. Source: Bloomberg, own computation.

2Y 3Y 4Y 5Y 7Y 10Y
Yields on 18 February 2022 4.48 4.68 4.88 5.12 5.30 5.62
Expected yields at 1 week (1 view) 4.62 4.80 5.06 5.50 5.92 6.22
Expected yields at 1 week (2 views) 4.62 4.79 5.12 5.38 5.93 6.24
Realized yields on 25 February 2022 4.62 4.86 5.07 5.38 5.70 5.92
Square error (1 view) 0.00 0.00 0.00 0.01 0.05 0.09
Square error (2 views) 0.00 0.00 0.00 0.00 0.06 0.11
J. Risk Financial Manag. 2022, 15, 247 29 of 37

Table 10. Weekly yield curve forecasts incorporating the trader’s views on 18 February 2022 and
realized yields on 25 February 2022. Source: Bloomberg, own computation.

2Y 3Y 4Y 5Y 7Y 10Y
Yields on 18 February 2022 4.48 4.68 4.88 5.12 5.30 5.62
Expected yields at 1 week (1 view) 4.62 4.80 5.06 5.50 5.92 6.22
Expected yields at 1 week (2 views) 4.62 4.79 5.12 5.38 5.93 6.24
Realized yields on 25 February 2022 4.62 4.86 5.07 5.38 5.70 5.92
Square error (1 view) 0.00 0.00 0.00 0.01 0.05 0.09
Square error (2 views) 0.00 0.00 0.00 0.00 0.06 0.11

We observe that the forecast method performs well even in times of severe market
turbulence for both one- and two-view approaches. This is also proved by the square errors
of estimations, which are very close to 0 in both situations.
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 31 of 39
One interesting observation was that for both one- and two-view forecasts, the estima-
tions were suggesting a steeper evolution of the term structure than what was actually
observed on the market 1 week later. This can be largely attributed to the way the covari-
that matrix
ance this model attributes
was built. Morehigher weights
precisely, it wastocomputed
more recent data.
using the As
EWMAwe recall
model, from Section
given that
5.2 of this article, the most recent pattern of the Romanian yield curve dynamics
this model attributes higher weights to more recent data. As we recall from Section 5.2 of starting
2022article,
this was that
theof a bear
most steepener).
recent pattern of the Romanian yield curve dynamics starting 2022
In addition
was that of a bear to the period surrounding the Russian war with Ukraine, which deter-
steepener).
mined intense volatility
In addition and a surrounding
to the period pronounced increase in the
the Russian level
war withof Ukraine,
interest rates
whichthrough-
deter-
out the CEE region and, implicitly, across the Romanian yield curve, we also
mined intense volatility and a pronounced increase in the level of interest rates throughout performed
the CEE
the above analysis
region and,forimplicitly,
the periodacross
surrounding the outbreak
the Romanian of SARS-CoV-2
yield curve, in March 2020.
we also performed the
We forecasted
above thethe
analysis for entire term
period structure ofthe
surrounding interest ratesofon
outbreak 28 February
SARS-CoV-2 in2020
March for2020.
6 March
We
2020 (Figure
forecasted the18 andterm
entire Tablestructure
11) and ofoninterest
13 Marchrates2020
on 28forFebruary
20 March 2020
2020 for(Figure
6 March 192020
and
Table 12)
(Figure 18 also
and based on and
Table 11) the one-view (the 2-year
on 13 March 2020 for yield) and two-view
20 March (2- and
2020 (Figure 5-year
19 and yields)
Table 12)
approaches:
also based on the one-view (the 2-year yield) and two-view (2- and 5-year yields) approaches:

4.1

3.9

3.7 Yields on 28 February 2020

3.5
Expected yields at 1 week (1
3.3 view)
Expected yields at 1 week (2
3.1
views)
2.9 Realized yields on 06 March
2020
2.7

2.5
6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

Figure 18.Weekly
Figure18. Weeklyyield
yieldcurve
curveforecasts
forecastsincorporating
incorporatingthe
thetrader’s
trader’s views
views on
on28
28February
February2020
2020and
and
realized
realizedyields
yieldson
on06
06March
March2020.
2020.Source:
Source:Bloomberg,
Bloomberg,own
owncomputation.
computation.

Table 11. Weekly yield curve forecasts incorporating the trader’s views on 28 February 2020 and
realized yields on 06 March 2020. Source: Bloomberg, own computation.

6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
Yields on 28 February 2020 2.86 2.96 3.15 3.20 3.45 3.56 3.77 4.02
Expected yields at 1 week (1 view) 2.76 2.67 3.03 3.06 3.25 3.42 3.52 3.76
Expected yields at 1 week (2
2.79 2.99 3.03 3.08 3.14 3.33 3.33 3.49
views)
Realized yields on 6 March 2020 2.85 2.86 3.03 3.11 3.27 3.33 3.52 3.84
Square error (1 View) 0.01 0.04 0.00 0.00 0.00 0.01 0.00 0.01
Square error (2 Views) 0.00 0.02 0.00 0.00 0.01 0.00 0.04 0.12
J. Risk Financial Manag. 2022, 15, 247 30 of 37

Table 11. Weekly yield curve forecasts incorporating the trader’s views on 28 February 2020 and
realized yields on 06 March 2020. Source: Bloomberg, own computation.

6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
Yields on 28 February 2020 2.86 2.96 3.15 3.20 3.45 3.56 3.77 4.02
Expected yields at 1 week (1 view) 2.76 2.67 3.03 3.06 3.25 3.42 3.52 3.76
Expected yields at 1 week (2 views) 2.79 2.99 3.03 3.08 3.14 3.33 3.33 3.49
Realized yields on 6 March 2020 2.85 2.86 3.03 3.11 3.27 3.33 3.52 3.84
J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 32 of 39
Square error (1 View) 0.01 0.04 0.00 0.00 0.00 0.01 0.00 0.01
Square error (2 Views) 0.00 0.02 0.00 0.00 0.01 0.00 0.04 0.12

5.5

5
Yields on 13 March 2020
4.5
Expected yields at 1 week (1
4 view)
Expected yields at 1 week (2
3.5 views)
Realized yields on 20 March
2020
3

2.5
6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

Figure
Figure19. Weekly yield
19. Weekly yield curve
curve forecasts
forecastsincorporating
incorporatingthe
thetrader’s
trader’sviews
views
onon
1313 March
March 2020
2020 and
and re-
realized yields on 20 March 2020. Source: Bloomberg, own computation.
alized yields on 20 March 2020. Source: Bloomberg, own computation.

Table 12.Weekly
Table12. Weeklyyield
yieldcurve forecasts
curve incorporating
forecasts thethe
incorporating trader’s views
trader’s on 13
views onMarch 20202020
13 March andand
realized
real-
yields on 20 on
ized yields March 2020. 2020.
20 March Source: Bloomberg,
Source: own computation.
Bloomberg, own computation.

6M 1Y 6M2Y 1Y 3Y 2Y 3Y
4Y 4Y5Y 5Y 7Y 7Y 10Y
10Y
Yields on 13 March 2020 Yields on 13 March 2020
3.28 3.00 3.28
3.90 3.00 3.91
3.90 3.91
4.03 4.03
4.31 4.314.41 4.41 4.84
4.84
Expected yields3.32
Expected yields at 1 week (1 view) at 1 week (1 view)
3.01 3.32
4.05 3.01 4.05
4.05 4.05
4.16 4.16
4.51 4.514.58 4.58 5.06
5.06
Expected yields
Expected yields at 1 week (2 views) 3.36 at 1 week (2
3.14 4.05 4.08 4.16 4.42 4.52 4.93
3.36 3.14 4.05 4.08 4.16 4.42 4.52 4.93
Realized yields on 20 March 2020 views)
3.31 3.56 4.05 4.22 4.44 4.42 4.97 5.45
Square error (1 View) Realized yields0.00
on 20 March 2020
0.30 3.31
0.00 3.56 0.03
4.05 4.22
0.08 4.44
0.01 4.420.16 4.97 5.45
0.15
Square error (2 Views) Square error
0.00 (1 View)
0.17 0.00
0.00 0.30 0.02
0.00 0.03
0.08 0.08
0.00 0.010.20 0.16 0.15
0.27
Square error (2 Views) 0.00 0.17 0.00 0.02 0.08 0.00 0.20 0.27

From Figure 19 and Table 12 above, we observe that only by providing a view on a
From Figure 19 and Table 12 above, we observe that only by providing a view on a
single tenor (the 2-year yield), the model performs extremely well across the entire term
single tenor (the 2-year yield), the model performs extremely well across the entire term
structure, but especially in the case of the belly and back-end zones of the curve.
structure, but especially in the case of the belly and back-end zones of the curve.
Interestingly, in the example from 28 February 2020, the model performed even better
Interestingly, in the example from 28 February 2020, the model performed even bet-
than in the case when the trader engaged two views. This is primarily due to the shape
ter than in the case when the trader engaged two views. This is primarily due to the shape
of the second principal component (PC2), which we incorporated in the estimation based
of the second principal component (PC2), which we incorporated in the estimation based
on the two views we provided for the 2- and 5-year tenors. We recall from the beginning
on the two views we provided for the 2- and 5-year tenors. We recall from the beginning
of this chapter that most often, our PCA analysis revealed that when the second principal
of this chapter that most often, our PCA analysis revealed that when the second principal
component increases by one unit, the short end of the yield curve increases, while the
component
longer increases by
end decreases, one unit,
leading the short end
to a flattening of yield
of the the yield curve
curve increases,
as the while the
second principal
longer end increases
component decreases, leading
(Table 13). to a flattening of the yield curve as the second principal
component increases (Table 13).

Table 13. Factor loadings, eigenvalues, and variances explained by the first two PCs on 28 February
2020. Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by Le-
onardo Volpi.

CumVar 70.52% 90.35%

Var 70.52% 19.83%
EigVal 592.25813 166.55078
PC1 PC2
J. Risk Financial Manag. 2022, 15, 247 31 of 37

Table 13. Factor loadings, eigenvalues, and variances explained by the first two PCs on 28 February
2020. Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by
Leonardo Volpi.

CumVar 70.52% 90.35%

Var 70.52% 19.83%
EigVal 592.25813 166.55078
PC1 PC2
6M 0.2377 0.2096
1Y 0.3926 0.7628
2Y 0.2862 0.1059
3Y 0.3102 0.1535
4Y 0.3963 −0.1365
5Y 0.3099 −0.1718
7Y 0.4177 −0.3202
10Y 0.4286 −0.4344

This is why in the case of the two-view approach, the estimation for the 1-year yield was
better than in the case of the one-view approach (the actual realized market yield was higher),
but performed more poorly in the case of the back-end zone. By taking into account the second
principal component in the forecast, we accounted for a flattening of the curve. However, in
real life, the curve bull flattened the following week, giving the one-view approach better
predictability results. This finding is consistent with the globally observed empirical data,
which support the idea that changes in the slope of the yield curve are consistent with those
implied by the shape of the first PC (Golub and Tilman 2000, p. 106). As a result, if a significant
market movement is expected, using the first PC to forecast the term change appears to be the
most historically plausible alternative (Golub and Tilman 2000, p. 106).

6. Conclusions
Principal component analysis (PCA) is a modern machine learning technique that has
been extensively used in discrete time finance in general and in the risk management of
fixed income instruments in particular, with the main purpose of reducing the dimensions
of risk factors. Even tough other deterministic approaches, such as the key rates method, are
more familiar among risk and portfolio managers, they do exhibit one major drawback:
their complex correlation and volatility structure make them less efficient in providing
inferences on the yield curve movements from a statistical perspective. Still, key rates
remain very useful in assessing certain patterns of the term structure as, for example, the
likelihood of a yield curve steepening or flattening between two key maturities that exhibit
high correlation.
The key rates approach, however, does not answer a whole class of questions, such as
what would the entire yield curve normally look like if the spot rate for a specific maturity
changes by a given number of basis points. This is one aspect we would like to know if
we had a view only on a specific tenor. Principal component analysis not only addresses
this type of questions, but also provides a probabilistic setting in the process of generating
yield curve scenarios. Generating yield curve scenarios of which shape and magnitude
plausibility can be quantitatively measured is one particular feature of PCA that this paper
addresses. Moreover, principal components’ factor loadings reflect the historical relationship
between key spot rates and have an intuitive interpretation, as they visually depict the
shape of the most dominant yield curve changes, meaning the principal components.
The first goal of this paper was to analyze how the PCA method manages to describe
the dynamics of the Romanian sovereign yield curve at different points in time, especially
before and after major events, such as the outbreak of the COVID-19 pandemic, the transi-
tion to hawkish monetary policy measures due to elevated levels of inflation, or the military
escalation of the Russian–Ukrainian conflict. In the second part, we extended the concepts
of historical plausibility of yield curve scenarios introduced by Golub and Tilman (2000) to
the Romanian government bond market. That is, we computed the measures of historical
J. Risk Financial Manag. 2022, 15, 247 32 of 37

plausibility (explanatory power, shape plausibility, and magnitude plausibility) for different yield
curve shocks, while quantitatively assessing for their historical likelihood. Eventually, we
used the forecasting model developed by Nogueira (2008) to derive the entire structure of
the Romanian yield curve while also incorporating the trader’s view on a few benchmark
interest rates.
For the purpose of our analysis, weekly changes of the Romanian government yields
between March 2019 and March 2022 were used to derive principal components (PCs)
via eigenvalue decomposition of the covariance matrix. The data set consisted of closing
midmarket yields corresponding to the 6-month and 1-, 2,- 3-, 4-, 5-, 7-, and 10-year tenors.
The covariance matrix was computed from exponentially weighted observations in order
to put more emphasis on recent market developments. We performed PCA for different
moments in time with emphasis on the 2020–2022 period. In our most recent data, that
is, 25 March 2022, we found that the first principal component (PC1) explained 80.83%
of the yield curve changes, the first two 91.92%, and the first three 96.87%. These results
are consistent with previous works from the literature, which state that the first three PCs
generally explain around 95% of the variability in the term structure.
Interestingly, we observed that the explanatory power of the first principal component
(the yield curve variance explained by the first PC) increases significantly following extreme
market events. Due to the start of the COVID-19 pandemic in 2020, the second half of
March was marked by extreme market movements on the government bond market, with
yields increasing by up to 150 basis points across the sovereign yield curve within only
2 weeks. On 28 February 2020, the first principal component explained only 70.52% of
the yield curve variability, the first two principal components 90.35%, and the first three,
95.71%. The explanatory power of PCs increased in the following weeks, such that on 20
March 2020, the first PC explained 91.51%, the first two 98.87%, and the first three, 99.62%.
This finding suggests that when market movements of such amplitude take place, they
usually reflect more of a level shift in interest rates.
Our observations are also consistent with those of Golub and Tilman (2000) in the sense
that interest rate movements tend to become more synchronized in a severely distressed
market environment, leading to higher correlations between maturities. For example, while
the correlation coefficient between the 2-year and the 10-year yields was 0.51 on 28 February
2020, within less than a month, it reached 0.82.
Another observation in our study was that the factor loadings corresponding to the
2-year maturity are lower than those corresponding to the 10-year maturity, suggesting that
in the case of a market sell-off, yields at 10 years will increase more than those at 2 years,
leading to a steepening of the yield curve. Similarly, in situations of market rallies, long-
term interest rates will decrease less than short-term ones, resulting in a flattening pattern.
An additional experiment was performed to investigate whether actual patterns
observed in the market support these theoretical findings. Weekly changes in the level
and slope of the Romanian sovereign yield curve were considered. Afterwards, data were
categorized such that the market was considered bull if the 10-year yield decreased by more
than 5 basis points in a week, bear if it increased by more than 5 basis points, and neutral
otherwise. Similarly, a change in the slope of the yield curve was categorized as steepening
if the spread between the 2- and the 10-year interest rates increased by more than 5 basis
points, flattening if it decreased by more than 5 basis points, and unchanged otherwise.
Over the 2-year period spreading from 20 March 2020 to 25 March 2022, the ratio of
bull flattenings to bull steepenings of the Romanian sovereign yield curve was 20 to 0, and the
ratio of bear steepenings to bear flattenings was 4.6 to 1. Bull flattening and bear steepening
patterns also seemed to dominate the period before the COVID-19 pandemic. However, the
proportions were different: the ratio of bull flattenings to bull steepenings was 5.5 to 1, and
the ratio of bear steepenings to bear flattenings was 4 to 1. The conclusions of this experiment
were consistent with what the factor loadings of the first principal component revealed, that
in the case of market sell-offs, yields at 10 years increase more than those at 2 years, leading
J. Risk Financial Manag. 2022, 15, 247 33 of 37

to yield curve steepenings, while in market rallies, long-term interest rates decrease less
than short-term ones, resulting in flattening patterns.
The patterns observed in our analysis are deeply rooted in the characteristics of the
Romanian government bond market, where they find logical explanations. For example,
in the immediate proximity of extreme events (such as the start of the Russian military
invasion in Ukraine or the start of the COVID-19 pandemic), Romanian government yields
marked increases of large magnitude, in bear-steepening movements. This is mainly due to
the fact that the 10-year segment is particularly sensitive to such stressful events, given the
offshore share that remains concentrated in the back-end zone of the yield curve. However,
part of the steepening pattern tends to reverse in the weeks following such shocks, as some
bull-flattening movements emerge in the form of market corrections.
Market movements of large amplitudes—such as the ones triggered by intense risk-off
or risk-on sentiments—not only determine yield curve reshaping, but also can launch
assets into oversold or overbought territories. In the case of fixed income instruments, the
oversold or overbought conditions can emerge at the level of the yield curve as a whole, or
only at specific maturities, causing the term structure of interest rates to become “too flat”
or “too steep”.
Apart from being a widely known technique used to reduce data complexity, PCA
can also be used by traders and portfolio managers to identify relative-value trading
opportunities. For example, it can highlight a segment of the yield curve that is too rich or
too cheap, in which the relative valuation is independent of the market direction (Credit
Suisse Securities Research and Analytics 2012, p. 3). This can be performed throughout the
computation of residual values as the difference between actually observed market yields
and reconstructed data (principal components). We observed that when PCA-reconstructed
data were revealing a “too flat” yield curve, generally, a steepening pattern followed. On
the other side, PCA residuals signaling “too steep” or “too expensive” yield curves were
generally succeeded by bull-flattening corrections.
When incorporating the concept of likelihood into scenario analysis, it improves its
outcome in the sense that it does not only help portfolio managers to assess the large losses
generated by extreme market events, but also associates a probability estimation for that
event to occur. We concluded that during the outbreak of the COVID-19 pandemic, both
explanatory power and shape plausibility were characteristic of the yield curve dynamics and,
from this point of view, historically plausible. However, when moving to the probabilistic
framework of weekly yield curve scenarios during the outbreak of the COVID-19 pandemic,
we found that on 13 March 2020, the magnitude plausibility of a weekly 102-basis-point
shift (in either direction) was 0.26% (corresponding to a three standard deviation). This
result suggests that the amplitude of market movements registered in that particular week
(up to 80–100 basis points increases across the yield curve) was highly improbable from a
historical perspective.
Finally, we use the forecasting model developed by Nogueira (2008) to derive the
entire structure of the Romanian yield curve while also incorporating a trader’s view on a
few benchmark yields. We observe that the forecast method performs well even in times
of severe market turbulence for both one- and two-view approaches (when we provide our
views on a single tenor or on two tenors). This is also proved by the square errors of
estimations that are very close to 0 in both situations.

Funding: This research received no external funding.

Data Availability Statement: Data supporting reported results can be accessed via the Bloomberg
platform.
Acknowledgments: The opinions expressed in this research paper are those of the author and do not
necessarily reflect the views of the institutions mentioned in the paper, nor do they engage them in
any way.
Conflicts of Interest: The authors declare no conflict of interest.
 J. Risk Financial Manag. 2022, 15, 247 34 of 37

J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 36 of 39

J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 36 of 39

Appendix A

0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0 PC4
0 PC4
-0.26M 6M1Y 1Y 2Y 2Y 3Y 3Y 4Y 4Y 5Y 5Y 7Y 7Y10Y 10Y PC5
-0.2 PC5
-0.4
-0.4
-0.6
-0.6
-0.8
-0.8
-1
-1
Figure A1. Factor loadings
A1. Factor loadings
of the fourth and fifth principal components on 2525March 2022. Source:
Figure
Figure A1. Factor
Bloomberg, loadings
own of theof
computation
the fourthfifth
fourth
of PCsand
and fifth principal
with theprincipal
components
components
use of a VBA on 25 on
March
add-in developed
March
2022. 2022. Source:
Source:
by Leonardo Volpi.
Bloomberg, own computation of PCs with the use of a VBA add-in developed by
Bloomberg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi. Leonardo Volpi.

Figure
FigureA2.
A2.Weekly
Weeklyyield
yieldcurve
curvepatterns
patternsatat25.03.2022
25.03.2022(last
(last5252weeks).
weeks).Source:
Source:Bloomberg
Bloombergyields,
yields,own
own
Figure A2. Weekly
computation ofyield
yieldcurve
curvepatterns
patterns.at 25.03.2022 (last 52 weeks). Source: Bloomberg yields, own
computation
computation of curve
of yield yield curve patterns.
patterns.
Table
TableA1.
A1.One-standard-deviation
One-standard-deviation PCA
PCAannualized
annualizedyield
yieldcurve
curveshocks
shocksand
andcorresponding
correspondingexplan-
explana-
Table A1.powers
atory One-standard-deviation
on 25 March 2022.PCA annualized yield curve shocks and corresponding explan-
atory tory powers
powers on 25onMarch
25 March
2022.2022.
Contribution (Explanatory
Annualized Shock (bps) 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
ContributionContribution
(Explanatory
Annualized Shock (bps) 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y power)
Annualized Shock (bps) 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y power)
PC1 shock 78 64 138 139 148 172 200 209 (Explanatory
80.83% Power)
PC1 shock
PC2 64
shock 138 78 6564 28 138 57139 148 36172 −1200 −61209 −84 80.83%
PC1 shock 78 139 148 71 172 200 209 11.16%
80.83%
PC2 shock
PC3 28
shock 65 28 57
78 71 46 −37 71 36 −1 −61 −84 8 11.16%
4.88%
PC2 shock 65 57 36 −19 −−19 1 −1−61 −40 −84 11.16%
PC3 shock Shock 78 46 144−37 144 −19 −1 144−40 144 8 144 4.88%
PC3 shock 78 Parallel 46 −37 144−19 −−19
19 144 −144 1 −40 8 73.33%
4.88%
Parallel Shock Parallel
144 YC Shock
PCAs
144Shock 144
144 221144
144 144
138 144
158
144 144
165 170
144 144 149144
144 144
133 221
144 73.33%
96.87%
73.33%
YC PCAs Shock YC PCAsBloomberg,
Source:
221 Shock
138 221computation
own
158 138
165 158 of170
165 170149
PCs with 149use of
the 133 221add-in
133a VBA 96.87%96.87%
221 developed by Leo-
Source: Bloomberg,
nardo Volpi. own computation of PCs with the use of a VBA add-in developed by Leo-
Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi.
nardo Volpi.
Table A2. Likelihood of principal components’ annualized yield curve shocks on 25 March 2022.
Table A2. Likelihood of principal components’ annualized yield curve shocks on 25 March 2022.
J. Risk Financial Manag. 2022, 15, 247 35 of 37

Table A2. Likelihood of principal components’ annualized yield curve shocks on 25 March 2022.

YC Annualized Shock (bps.) Corresp. STDEV Likelihood

50 0.35 36.32%
144 1.00 15.87%
100 0.69 24.51%
150 1.04 14.92%
200 1.39 8.23%
225 1.56 5.94%
250 1.73 4.18%
Source: Own computation.

Table A3. Two-standard-deviation PCA annualized yield curve shocks and corresponding explana-
tory powers on 25 March 2022.

Annualized Shock of Same Shape (bps) 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

PC1 shock 155 129 275 278 297 343 401 417
PC2 shock 130 56 115 141 72 −1 −121 −169
PC3 shock 156 91 −73 −39 −39 −1 −80 17
Parallel Shock 289 289 289 289 289 289 289 289
YC PCAs Shock 441 276 317 330 341 297 266 441
Source: Bloomberg, own computation of PCs with the use of a VBA add-in developed by Leonardo Volpi.

Table A4. Shape plausibility of actual yield curve evolution on 13 March 2020. Source: Own
computation.

θi θM,i θL,i (θi −θM,i )2 (θL,i −θi )2

PC1 99.97% 97.78% 0.00% 0.00 0.96
PC2 0.01% 1.22% 0.00% 0.00 0.00
PC3 0.02% 0.66% 0.00% 0.00 0.00
PC4 0.00% 0.19% 0.00% 0.00 0.00
PC5 0.00% 0.07% 0.00% 0.00 0.00
PC6 0.00% 0.04% 0.00% 0.00 0.00
PC7 0.00% 0.02% 0.00% 0.00 0.00
PC8 0.00% 0.01% 100.00% 0.00 1.00
Sum of Squares 0.03 1.40
Shape Plausibility 98.15%

Notes
1 By the time Golub and Tilman wrote the book Risk Management: Approaches for Fixed Income Markets in 2000, there were only a few
proprietary and government trading desks that used principal component durations in weighting butterfly yield curve trades
and in other portfolio management and trading decisions.
2 Due to the outbreak of the COVID-19 pandemic in 2020, the second half of March in particular was marked by extreme market
movements on the government bond market, with yields increasing by up to 150 basis points across the sovereign yield curve
within only 2 weeks.
3 In unsupervised learning, models are trained to find patterns or methods for data subgrouping or categorization based on
variables and observations. Such unsupervised learning techniques include principal component analysis (PCA) and a range of
clustering methods. On the other hand, in supervised learning, predictive models are developed through the use of classification
and regressions (logistic regression and neural networks, to name a few). While supervised learning models are trained by
comparing their output against known true observations, in unsupervised learning, no correct answer is provided throughout
the training phase.
4 Obtained from RiskMetrics® (monthly data set).
5 That day was market by a dramatic increase in U.S. interest rates as a result of the credit and liquidity crisis in 1998. The shock
was characterized by a day-on-day 10-basis-point increase in the 3-month yield, an approximately 20-basis-point move in the
intermediate zone of the yield curve, and an about 7-basis-point change in the 30-year spot rate.
6 By definition, a standard normal variable N(0,1) has a mean of 0 and a standard deviation of 1.
7 Generally 1 year.
 J. Risk Financial Manag. 2022, 15, 247 36 of 37

8 Unlike the factor models developed by Nelson and Siegel (1987) and Diebold et al. (2008), where factors have an intuitive
interpretation (level, slope, curvature) but calibration is nonlinear, so models lose part of their tractability.
9 For an extensive review of Nogueira’s model, see the chapter “Expressing Views” in his work “Updating the Yield Curve to
Analyst’s Views”, specified in Note 19 in this article.
10 https://ec.europa.eu/info/business-economy-euro/recovery-coronavirus/recovery-and-resilience-facility/recovery-and-resil
ience-plan-romania_en, accessed on 21 March 2022.
11 With lambda set at 0.8, in order to capture the effects of very recent market dynamics, especially around extremely stressful
events, such as the start of the COVID-19 pandemic or the start of the Russian military invasion of Ukraine.
12 Available at https://learn.bowdoin.edu/excellaneous/#downloads, accessed on 21 March 2022.
13 Due to the start of the COVID-19 pandemic in 2020, the second half of March in particular was marked by extreme market
movements on the government bond market, with yields increasing by up to 150 basis points across the sovereign yield curve
within only 2 weeks.
14 Similar to the one performed by Golub and Tilman (2000) on the U.S. Treasury curve, 105.
15 In November 2021, the offshore exposure to ROMGBs reached 16.5%, a 3.6 percentage points drop from the 20.1% level registered
in December 2020. By the end of February 2022, the offshore share in Romanian local debt further decreased to 15.7%, suggesting
an underweight position.
16 In the months preceding this event, demand for ROMGBs increased, given that investors had been gradually pricing in the rising
chances for early elections; also, until that moment, the demand for Romanian government bonds was sustained by supportive
liquidity conditions on the market.
17 The 10-year Romanian government bond yield reached 6.41% on 11 March 2022.
18 “Updating the Yield Curve to Analyst’s Views”, Nogueira (2008).

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