Yield Curve Smoothing and Residual Variance of Fixed Income Positions

Raphael Douady ()

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

Keywords: interest rate models; arbitrage pricing; infinite dimensional models; Martingale methods (search for similar items in EconPapers)
Date: 2014-12
Note: View the original document on HAL open archive server: https://hal.science/hal-01151276
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Citations: View citations in EconPapers (3)

Published in 2014

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Related works:
Working Paper: Yield Curve Smoothing and Residual Variance of Fixed Income Positions (2014)
Working Paper: Yield Curve Smoothing and Residual Variance of Fixed Income Positions (2014)
Working Paper: Yield Curve Smoothing and Residual Variance of Fixed Income Positions (2013)
Working Paper: Yield Curve Smoothing and Residual Variance of Fixed Income Positions (2013)
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