COMPARISON OF THE PRINCIPAL COMPONENT·

BASED FIXED INCOME HEDGING STRATEGIES

by

Alexander Rozov
Bachelor of Mathematics, Moscow Institute of Economics and Statistics, 1994
PhD in Economics, Moscow State University of Economics, Statistics and Informatics, 1998

Mengxin (Simon) Gan

Bachelor of Business Administration, Simon Fraser University, 2006

PROJECT SUBMITIED IN PARTIAL FULFILLMENT OF

THE REQUIREMENTS FOR THE DEGREE OF

MASTER OF ARTS

In the Faculty
of Business Administration

© Alexander Rozov and Mengxin (Simon) Gan 2007

SIMON FRASER UNIVERSITY

Summer 2007

All rights reserved. This work may not be

reproduced in whole or in part, by photocopy
or other means, without permission of the author.
APPROVAL

Name: Alexander Rozov

Mengxin (Simon) Gan

Degree: Master of Arts

Title of Project: Comparison of the Principal Component-Based

Fixed Income Hedging Strategies

Supervisory Committee:

Dr. Daniel Smith

Senior Supervisor
Associate Professor, Faculty of Business Administration

Dr. Christopher Perignon

Second Reader
Associate Professor, Faculty of Business Administration

Date Approved:

ii
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ABSTRACT

This study analyses and compares various Principal Component-based

methods of fixed income security immunization. We show that the methods are

effective in terms of reducing the volatility of the security returns; however, none

of the Principal Component-based techniques outperforms the mean-variance

optimization. We conclude that the Principal Component-based immunization is

more effective when including all the available underlying securities in the

portfolio instead of hedging with the limited number of selected underlying

securities. We show that the Principal Component-based methods are not

effective for hedging short-term securities. We conclude that application of the

Principal Component-based immunization techniques requires balancing the

contrary effects of the model error and the estimation error on the results.

Keywords: Immunization; Hedging; Principal components; Fixed income

securities; Systematic and idiosyncratic risks

iii
ACKNOWLEDGEMENTS
We would like to thank Dr. Daniel Smith for sharing his ideas, knowledge

and expertise with us.

We also like to thank Dr. Christopher Perignon for his valuable comments

on the project.

iv
TABLE OF CONTENTS

Approval ii
Abstract iii
Acknowledgements iv
Table of Contents v
List of Figures vi
List of Tables vii
1 Introduction 1
2 Principal Component-based Fixed Income Hedging Strategies 6
3 Data Description 14
4 Empirical Results : 16
5 Conclusion 21
Appendices 23
Reference List. 35

v
LIST OF FIGURES

Figure 1 Annualized weekly returns on the fixed income securities 25

Figure 2 Factor loadings of the fixed income securities returns 28

vi
LIST OF TABLES

Table 1 Descriptive statistics 23

Table 2 Eigenvectors and eigenvalues for the fixed income securities
returns 27
Table 3 Comparative effectiveness of different immunization methods by
the example of weekly returns on 3-year US Treasury Bonds 29
Table 4 Comparative effectiveness of different immunization methods by
the example of weekly returns on 5-year zero coupon fixed
income security 30
Table 5 Comparative effectiveness of different immunization methods by
the example of weekly returns on 1-month US Treasury Bills 31
Table 6 Comparative effectiveness of different immunization methods by
the example of weekly returns on 6-month zero coupon fixed
income security 32
Table 7 Comparative effectiveness of different immunization methods by
the example of weekly returns on 10-year US Treasury Bonds 33
Table 8 Comparative effectiveness of different immunization methods by
the example of weekly returns on 20-year zero coupon fixed
income security 34

vii
1 INTRODUCTION

Financial institutions consider liability hedging an integral part of their

investment strategies. The problem is important for banks and financial

companies, which seek to mitigate their exposure to market risk, to reduce

regulatory capital charges, and to lower their cost of capital. Liability

immunization is especially important for pension funds and insurance companies,

which have significant cash outflows outstanding. The problem also arises for

non-financial companies that actively use debt funding, operational lease

financing and/or futures/forward agreements.

One of the methods aimed at reducing the risks associated with liability

stream volatility is duration immunization, a popular technique of managing risks

described in most course books on fixed income security analysis such as

Fabozzi (2006) or Tuckman (2002). The method assumes that the only driving

force of the change in security returns is the parallel shift in interest rates. In

practice, this assumption turns out to be unrealistic because it ignores other

drivers of movements of the security returns such as changes in the interest rate

curve slope and curvature. Besides, assuming that returns of the securities with

different maturities are independent, the method does not take into account the

correlation between the returns of the securities with different maturities (phoa,

2000).
 The Principal Component-based methods of immunization benefit from the

lack of the shortcomings that the duration-based approaches have. The Principal

Components represent a set of independent factors that explain significant part

of the variation of security returns. Once knowing those factors, it is possible to

hedge certain liability stream by choosing underlying fixed income securities to

offset the variations of the factors.

The Principal Component-based methods have been proved effective in

fixed income hedging. The three most important factors that cause changes in

fixed income security returns are associated with level, slope and curvature of

the interest rate curve (Falkenstein and Hanweck, 1997). Litterman and

Scheinkman (1991) and Knez, Litterman, and Scheinkman (1994) show that the

first three principal components explain a large proportion (up to 98%) of bond

return variations. Based on effects that those three components produce on the

security returns, Litterman and Scheinkman (1991) interpret them as level, slope

and curvature factors. Diebold, Ji and Li (2004) confirm the previous findings and

show that these three factors describe a great proportion of the systematic risks

of bond returns.

Bliss (1997) compares the duration-based and the Principal Component-

based methods and shows that the latter outperform the duration-based

approaches. The paper presents evidences that the Principal Component-based

hedge error is at least twice as small as that of the duration-based immunization.

Having tested the Principal Component-based immunization on the same set of

data using different subperiods, the author concludes that the three common

2
factors effectively capture volatility of the interest rates in all periods, though the

bond loadings on the factors slightly change over time.

The findings of the previous paper were further expanded and enriched by

Perignon and Villa (2006). They explore time-varying covariance matrix for

calculating the Principal Components for US interest rates. The authors reveal

that time-varying covariances and, as a result, time-varying factor loadings of the

returns are more consistent with the economic reality than constant covariances,

which are rejected in the most of the experiments conducted.

The works mentioned above apply the Principal Component Analysis to

sovereign debt markets. Bertocchi, Giacometti and Zenios (2005) test

effectiveness of the Principal Component Analysis by the example of the U.S.

corporate debt market. The conclusions of the paper are encouraging: the

common factors explain 98% of variation in the corporate bond yields and

spreads. Those results remain stable when the method is applied to the bonds

that have different credit ratings or belong to different corporate sectors.

Alongside with the advantages of the Principal Component-based hedging

and positive results obtained, the literature describes problems and limitations

associated with the methods. Thus, Reisman and Zohar (2004) show that the

hedging based on the Principal Component Analysis implies existence of

arbitrage, that is, the self-financing riskless hedging portfolios might have non-

zero returns. This is a contradiction to the market efficiency theory. The

phenomenon can be compared with the 'volatility smile' effect in derivatives

markets.

3
 Perignon, Smith, and Villa (2005) compare the effectiveness of the

Principal Component-based methods in different countries and conclude that,

while for each country the three common factors explain most of the volatility of

the returns volatility, only one factor is common across different countries. This is

due to the fact that the Principal Component Analysis takes into account

correlation between the bonds with different maturities but not of different

countries.

McGuire and Schrjjvers (2003) study emerging bond markets of 15

developing countries and reveal that the common factors are able to capture only

one third of the volatility on the bond returns; whereas the other two third is

caused by idiosyncratic factors. Thus, the Principal Component-based

immunization is significantly less effective in emerging markets.

While the literature on the Principal Component-based immunization

mostly focuses on how to effectively hedge the systematic risks, little is known

about the influence that different approaches to selecting the underlying

securities make on the effectiveness of hedge. Besides, no research has been

done on how to minimize effectively both systematic and idiosyncratic risks of

fixed income securities.

The purpose of this study is to compare various mechanisms of selecting

the underlying fixed income securities to the hedging portfolio, to extend the

Principal Component-based technique to hedge against both systematic and

idiosyncratic risks and to compare the effectiveness of different Principal

Component-based strategies of immunization of fixed income securities.

4
Specifically, we use the Principal Component Analysis to extract common factors

explaining the variation in fixed income security returns. We elaborate on seven

different approaches to selecting the underlying securities. Then we construct

self-financing portfolios which minimize the factor exposures of the liability

stream associated with the chosen fixed income security to the variations of the

factors. In the empirical analysis, we apply all the techniques to two datasets,

U.S. Treasury security returns over the last 25 years and bootstrapped U.S. zero

coupon fixed income security returns for the period from 1988 to 2004. Finally,

we compare effectiveness of different Principal Component-based methods.

The rest of the project is organized as follows. Section 2 presents the

Principal Component-based methods of a liability stream immunization. Section 3

provides data description and statistics. Section 4 describes the results obtained

by applying seven different hedging strategies. Section 5 summarizes our

findings and observations.

5
2 PRINCIPAL COMPONENT-BASED FIXED INCOME
HEDGING STRATEGIES

Suppose we need to immunize a liability stream. For this purpose we

create a portfolio of fixed income securities that mimics the liability stream but is

not exposed (or is exposed to the less extent than the liability stream) to

systematic risks. Then, we hedge our liability stream using that portfolio. As a

result, the new liability stream is exposed only to idiosyncratic risks of individual

securities.

One of the solutions of the problem is to create the global minimum

variance portfolio that includes the short position in the liability stream and long

(and possibly short) positions in the underlying securities. The mean-variance

optimization technique can be used to obtain such a hedging portfolio.

In matrix notation the mean-variance problem can be presented as

follows. The objective function is:

minN w'..[ w.
WER

The following constraints have to be imposed in order to construct a self-

financing hedging portfolio for bond j, which creates the liability stream we wish

to immunize:

ejw=-1,

i'w = O.

6
where ej is a vector containing unity in the row j and zeros in the other rows, i is

a vectors of unities.

The mean-variance problem can be solved using the Lagrangian:

L = w'I w - A] (e;w + 1)- A2 (i'w).

In matrix notation, the first order conditions for the extremal values of L are the

following:

This expression allows us to compute the vector of weights w:

The Principal Component-based methods of immunization consist in

extracting the common factors affecting the returns of all the securities,

calculating the security loadings on the factors and then constructing a self-

financing portfolio with zero loadings on the factors. Mathematically, the Principal

Component Analysis transforms the set of correlated variables to a set of

orthogonal variables (factors). Linear combinations of the factors replicate the

original correlated variables (Amenc and Marellini, 2002).

In matrix notation, the M-factor model for N fixed income security returns

R, at time t can be presented as follows:

7
where R, is a vector of size N containing the returns on the securities at time t, A

is a matrix of size [NxM] comprising security loadings on the factors, Ft is a vector

of size M containing the values of the common factors at time t, Et is a vector of

size N containing the residuals at time t, which are specific for each fixed income

security. We assume that common factors F are orthogonal, and the factors and

residuals have zero mean. In this model A represents systematic risks and E

introduces idiosyncratic risks associated with each security.

The Principal Component Analysis approach includes decomposition of

the covariance matrix of the bond returns X as follows:

X =AI\A',
where 1\ is the covariance matrix of the factors. Such decomposition always

exists because X is a positive-semidefinite matrix. Since the factors are

orthogonal, 1\ is a diagonal matrix, whose diagonal elements are the eigenvalues

of the covariance matrix X. Since we assume that COV(Ft,Et) =0, when using only
M first common factors for the analysis, the covariance of the security returns can

be presented as follows:

X =A1-MI\1-MA1-M'+ n,
where A 1-Mis the first M columns of the matrix A, 1\1-M is the covariance matrix of

the factors 1, ... , M, n =E(EE') is the covariance matrix of the residuals.

Willing to hedge security j against variations in the common factors, we

impose linear constraints on the portfolio weights w. For example, for hedging

8
against the variation in the first factor only the following constraints have to be

imposed:

A 1 'w = 0,

ejw=-1,

i'w = 0,

where A 1 is the first column of the matrix A.

The system of linear constraints described above has a unique solution

only if the number of securities in the portfolio is equal to the number of factors to

be hedged against plus two. For example, to hedge certain security against the

variations in one factor, we need to include two more securities in the portfolio. In

this case the portfolio weights can be computed as follows:

A;j-lrO1
w =;~
[ ~1 .
By analogy with the case of hedging against one factor, the weights of the

portfolio components that guarantee protection against the volatility in the first

and second factor or the first, second and third factors can be calculated as

follows:

A; -I a
A; -I a
A'2 a
W=
A; a
and W= A'3 a , respectively.
e'.1 -1
e'1 -1
r a
a
r

9
Obviously, the unique solutions of these systems of equations exist only if the

number of bonds in the portfolio is equal to four and five, respectively.

When dealing with a number of securities available for hedging, the

problem that arises is which particular two (three or four) securities have to be

chosen to hedge certain liability stream. There might be a number of approaches

to solve this problem. The simplest approach is to choose the securities

randomly. However, in such a case the properties of different fixed income

instruments (volatility, specific risks, etc.) are not taken into account.

Another approach is to construct a 'butterfly' portfolio, which assumes

hedging the mid-term liability with short-term and long-term securities. The idea

of this approach is to create the hedging portfolio that is balanced in terms of

sensitivity to interest rate changes. One can also wish to find the underlying

bonds with the minimal residual variances o; which implies the lowest specific

risks.

All of the Principal Component-based approaches presented above have

a common shortcoming. They use the limited number of the underlying securities

and thus do not exploit all the opportunities in the market for the better hedge.

The next group of the Principal Component-based methods implies

construction of the portfolio using all available securities in the market. In order to

get rid of an uncertainty about which set of weights to use (the systems of linear

equations above have the infinite number of decisions when the number of linear

constraints is lower than the number of the unknown variables), an additional

criterion has to be used. For example, the criterion can consist in reducing

10
idiosyncratic risks of the portfolio or balancing the weights of the portfolio

individual components.

Numerically, the second group of methods requires solving the

optimization problem with the following criterion function:

minN w'Cw,
WER

where C is a matrix of size [NxN] that defines the criterion, N is the number of all

the available bonds in the market, and the following linear constraints:

Ak'w=O, k= 1, ..., M,

ejw=-1,

i'w= 0,

where M - the number of the common factors to hedge against.

The optimization problem introduced above can be solved using the

Lagrangian:

The first order conditions for the extremal values of L in matrix notation are the

following:

C Al AM ej i w
A; 0 0 0 0 A, ONxl

= OMxl
A~ 0 0 0 0 AM -1
ej 0 0 0 0 AM+ I 0
i 0 0 0 0 AM+ 2

11
from which the vector of weights w can be calculated as it was shown above for

the case of the mean-variance problem.

As we have already said, using a criterion function to create the hedging

portfolio allows us to get additional benefits from hedging. In order not only to get

rid of systematic risks but also to mitigate idiosyncratic risks of the securities, we

assign the covariance matrix of the residuals 0 to the matrix C. Assuming that

the residuals of different securities are independent, which is a plausible

assumption since each residual presents specific (independent) risk for the

correspondent fixed income instrument, we can simplify our task and, instead of

0, use a diagonal covariance matrix containing variances of the residuals as the

diagonal elements.

Remarkably, when using the full covariance matrix as a criterion function,

we obtain the optimization problem which is equivalent to the mean-variance

one. Indeed, since I" = A 1-MI\A1-M'+0 and W'Ak=O, k = 1, ... , M,the following is

true:

min w'I w
WERN
= min (W'A
WERN I-M
AA'I-M W+ W'.f.MtJ = min w'n W .
WER N

Thus, the two problems should give us the same result.

We can also focus on the purposes other than specific risk reduction when

constructing the matrix C. One of them can be diminution of differences in the

weights of the portfolio components. This can be achieved by assigning the

identity matrix I to the matrix C. Then the criterion for the optimization will be

minimization of the variations of the portfolio weights.

12
 Regarding the practical applications of the Principal Component-based

methods, we would like to mention an empirical issue associated with the

calculation of the covariance matrices L and fl. Jobson and Korkie (1980) show

that when the number of financial instruments in the market is large and

comparable with the number of available historical observations in the sample,

the covariance matrix L is computed with plenty of errors, which might generate

unreliable results. When computing the covariance matrix of the residuals fl,

computational errors becomes even larger because, assuming that the common

factors capture most of the variability of the returns, the residuals tend to zero.

13
3 DATA DESCRIPTION

We use two datasets of returns on fixed income securities. The first one

consists of weekly returns on U.S. Treasury zero coupon bills with maturities 3, 6

months and 1 year and U.S. Treasury coupon bonds with maturities 2,3,5,7,10

years for the period from 1982 to 2007 1 . Totally, we obtain 1324 observations for

the 8 securities. The second dataset consists of weekly returns on the

bootstrapped zero coupon securities with maturities 0.5, 1, 1.5,2,2.5, ... , 10

years (totally 20 securities) for the period from 1988 to 2004 2 . The second

dataset numbers 886 observations. The dataset statistics is presented in Table 1.

For both datasets, the standard deviation of the returns, which is a

measure of volatility, becomes larger with increasing maturity of the securities.

The same observation can also be done from the Figure 1. The distributions of

the returns are skewed. The largest asymmetry appears in the first dataset for

the returns of the short-term securities. The distributions are leptokurtic: the

kurtosises of the returns of the zero coupon securities are slightly higher than

those of normal distributed variables; whereas the distributions of the returns on

the U.S. Treasury securities are more peaked. In both cases, the short-term

1 The returns are calculated based on the yields of the US Treasury securities with constant
maturities obtained from the USA Federal Reserve Board website:
http://www.federalreserve.gov/releases/h15/data.htm The following technique is used for the
calculation of the coupon bond returns: on each weekly interval [t, t+1] the bonds are
considered issued and traded at par at time t and priced with 1-week accrued interest at time
t+1; the return calculated as annualized growth rate of the price for a week.
2 The returns are computed based on the bootstrapped zero coupon securities obtained from
Christopher S. Jones' page in the University of South California website: http://www-
rcf.usc.edu/-christojlresearch_wp.htm. We thank Christopher S. Jones for publishing the data.

14
security returns are more leptokurtic than the mid- and long-term ones. For the

first dataset, there are minor first-order autocorrelations of the returns; whereas

the returns from the second dataset demonstrate no significant autocorrelations.

The Principal Component Analysis applied to the both datasets reveals

that variation in the first factor capture the majority of the return volatility (Table

2). For the first dataset, 96.37% of the return volatility is explained by variability of

the first factor; whereas changes in the second and third factors contribute

additional 2.16% and 0.58% to the returns volatility, respectively. For the second

dataset, variability of the first factor captures 97.86% of the return fluctuations;

the second and third factors explain 1.80% and 0.28%, respectively.

The loadings of the returns on the first factor are negative for both

datasets (Figure 2). Their absolute values increase with maturities of the

securities; thus, changes in the first factor slightly affect the short-term security

returns and have more significant influence on the long-term security returns.

There is no similar pattern in which variations in the second and third factors

affect the returns of the securities of the two datasets. Yet, as in the case of the

first factor, the second and the third factors have different influence on the short-

mid- and long-term security returns. On the whole, the Principal Component

Analysis reveals that the returns of the short-term securities are less sensitive to

the variations of the factors; whereas the returns of the long-term securities are

more volatile and unstable.

15
4 EMPIRICAL RESULTS

For both datasets described above we exploit the Principal Component-

based immunization techniques using:

the limited (minimal necessary) number of underlying securities

that are either:

randomly selected, or

have minimal residual volatilities, or

form 'butterfly' portfolio (whenever applicable);

the entire number of available underlying securities minimizing:

the portfolio residual volatility using the full covariance matrix

of the residuals;

the portfolio residual volatility using the diagonal covariance

matrix of the residuals;

the variance of the portfolio weights.

We apply the techniques listed above to immunize against weekly variations in

one, two and three factors. We compare the Principal Component-based

methods with the mean-variance approach to the liability stream immunization.

We apply all the methods to hedge mid-term as well as short-term and long-term

16
liability streams using rolling and expanding window techniques. The results

obtained are presented in Tables 3-8.

In all the cases presented, the mean-variance optimization gives the best

results in terms of minimization of the out-of-sample volatility of the returns. So

does the Principal Component-based method that minimizes portfolio residual

volatility using the full covariance matrix of the residuals. As it was discussed in

Chapter 1, the two approaches are theoretically equivalent. However, in practice,

the covariance matrix of the residuals is estimated with a lot of errors in all the

cases", This is the reason that the results obtained using the two methods are

different in some cases. Significant estimation error makes the results obtained

using the Principal Component-based method that minimizes portfolio residual

volatility using the full covariance matrix of the residuals unreliable and its

practical application inexpedient. Our further discussion does not include this

method.

Despite the fact that the first factor captures the significant proportion of

the return volatility (96.37% for the first dataset and 97.86% for the second

dataset) (Table 2), whereas the second factor explains only 2.16% and 1.80%,

respectively, and the third factor captures even less (0.58% and 0.28%,

respectively), hedging against two and three factors improves the results

dramatically in most of the cases compare to hedging only against the first factor.

3 For the first dataset, the estimated covariance matrix of the residuals turns out not to be
positive-semidefinite in 414, 516, and 418 out of 804 rolling windows and in 416,494, and 410
out of 804 expanding windows when hedging against variations in one, two and three factors,
respectively. For the second dataset, the correspondent numbers are 193, 263, and 179 out of
366 rolling windows and 197,264, and 188 out of 366 expanding windows.

17
Those results are consistent with the literature. Thus, Litterman and Scheinkman

(1991) show that, despite relatively little contribution of the second and third

factors to the explanation of the variability of the bond yields, the results of

hedging against three factors outperform those when immunizing against one

factor by 28%. Further, Bliss (1997) investigates the problem and concludes that

a single-factor hedging model is effective only if the changes in yields of different

securities are perfectly correlated, which is not the case in the real world where a

certain part of non-parallel shifts in yields is not correlated with parallel shifts.

However, when choosing the number of the factors to immunize against,

one should have in mind two types of errors arising: the model error and the

estimation error. As it has been said above, taking into account the small number

of the factors and ignoring other ones potentially increases the model error. On

the other hand, adding more factors into account the estimation error increases

and might offset the positive effect of the immunization. In some cases

presented, the largest decrease in volatility is achieved when hedging against

one or two factors, and immunization against more factors only worsens the

results".

Although the Principal Component-based methods that imply using all the

available underlying securities are more effective than those based on the

selection of the minimal necessary number of underlying securities, this is not the

case when immunizing the short-term security in the case of the first set of data

(Table 5). Choosing the underlying securities with minimal residual volatilities is

4 This situation is more often for the U.S. Treasury security dataset (Tables 3, 5 and 7).

18
more effective than including in the portfolio the entire set of the securities and

calculating their weights by minimizing the portfolio residual volatility or the

variance of portfolio weights. Moreover, for both datasets, immunization of the

short-term securities does not significantly reduce but in most cases increases

volatility of the returns". These results are consistent with those one could

expect: short-term fixed-income securities have low volatility of the returns, and

choosing more volatile mid- and long-term underlying securities for hedging

brings no or little effect.

Immunization is found to be more efficient when the larger number of

securities and more variety of maturities are available for hedging. The second

dataset, which includes 20 different securities, allows us to achieve more

significant reduction in the out-of-sample volatilities than the first dataset",

Moreover, when the Principal Component techniques based on the selection of

the minimal necessary number of underlying securities are applied, the limited

available range of maturities for hedging, as in the case of the first dataset, might

lead to the increase of the out-of-sample volatilities? The same factor, along with

the estimation error mentioned above, causes the increase in the out-of-sample

5 See, for example, Tables 5 and 6. The rolling window mean volatilities of returns on 1-month US
Treasury Bill and 6-month zero coupon security are 0.0134 and 0.0259, respectively. All the
immunization techniques, except for the mean variance approach and the Principal
Component-based method that uses the full covariance matrix of the residuals to minimize
their volatility, generate higher volatilities.
6 However, in practice, including a large number of securities in the hedging portfolio increases
the transaction cost of hedging.
7 See, for example, Tables 3 and 7, both rolling and expanding windows, the method which uses
minimum residual volatility as a criterion for the securities selection.

19
volatilities when adding more factors to immunize against. In some cases, the

resulting growth in volatility becomes extremely larqe",

For both datasets, the Principal Component-based methods involving the

use of all the available underlying securities allow us to achieve not only more

significant decrease in the out-of-sample volatilities than the methods which

imply constructing the hedging portfolio using a limited set of securities but also

lower standard deviation of the out-of-sample volatilities and thus more stable

results. This is proved by the results obtained from both datasets using both

rolling and expanding window approaches. Besides, in terms of reduction of the

out-of-sample volatilities, minimizing the portfolio residual volatility using the

diagonal covariance matrix of the residuals is more efficient in most cases than

minimizing the variance of the portfolio weiqhts".

6 See Table 3, expanding windows, and Table 7, rolling windows, in both cases the method which
uses minimum residual volatility as a criterion for the securities selection when hedging against
three factors.
9 Especially when hedging against two and three factors.

20
5 CONCLUSION

In this study, we analyze different Principal Component-based methods of

liability stream immunization. The methods are found to be effective in terms of

offsetting the changes in the hedged liability streams. They provide

comprehensible and straightforward approach to hedging. Allowing an analyst to

choose to what extent and against which factors he or she is willing to hedge, the

methods imply flexible approach to immunization. Besides, some of the Principal

Component-based methods allow an analyst to impose additional requirements

on hedging portfolio. However, none of the Principal Component-based methods

considered in this study succeeds to outperform the mean-variance approach.

We conclude that the Principal Component immunization techniques

based on including in the hedging portfolio all the underlying bonds available for

hedge are more effective in terms of reduction of the portfolio volatility than the

methods based on selecting the minimal number of underlying securities required

for hedge. The results of this paper also evidence that greater variety of

maturities of the underlying securities available for hedge leads to more

significant decrease in the portfolio volatility.

Since short-term security returns are less volatile than those of mid- and

long-term securities, it is impossible to achieve satisfactory results applying the

Principal Component-based methods to immunize short-term liability streams.

21
We conclude that the immunization techniques other than the Principal

Component-based have to be used for hedging in that case.

Finally, we conclude that one who decides to use the Principal

Component-based methods for liability stream immunization has to balance the

positive effect achieved from choosing larger number of different factors to hedge

against (and thus from reduction of the model error) and the negative effect of

the estimation error that increases with adding more factors to the model.

22
APPENDICES

Table 1 Descriptive statistics

Panel A: US Treasury securities
Annualized weekly returns on the U.S. Treasury securities of 1-month, 6-month, 1-year, 2-year, 3-
year, 5-year, 7-year and 10-year constant maturities (8 issues) are obtained for the period from
1982/01/08 to 2007/05/25 by converting weekly yields into returns. The following technique is
used for the calculation of the coupon bond returns (with maturities 2-year, 3-year, 5-year, 7-year
and 10-year): on each weekly interval [t, t+1] the bonds are considered issued and traded at par
at time t and priced with 1-week accrued interest at time t+1; the return calculated as annualized
growth rate of the price for a week. Totally 1324 observations are obtained. Std.Dev. stands for
standard deviation, Rho (1), Rho (2), Rho (3) for autocorrelations at lags 1, 2 and 3 weeks,
respectively.

Excess
Maturity Mean Std. Dev. Skewness Rho (1) Rho (2) Rho (3)
kurtosis
3 months 0.0007 0.0200 3.1200 42.0522 0.1775 0.0004 -0.0218
6 months 0.0016 0.0371 2.5611 27.1316 0.1980 0.0412 -0.0015
1 year 0.0032 0.0675 2.2115 20.4161 0.2541 0.0574 0.0480
2 years 0.0002 0.1590 0.1564 8.2346 -0.3661 -0.1227 -0.0269
3 years 0.0005 0.2337 0.2218 4.8311 -0.3705 -0.1324 0.0054
5 years 0.0011 0.3549 0.2431 3.2634 -0.3537 -0.1680 0.0416
7 years 0.0017 0.4512 0.2373 2.4414 -0.3549 -0.1723 0.0550
10 years 0.0028 0.5586 0.2586 2.4043 -0.3548 -0.1756 0.0640

23
 Panel B: Zero coupon fixed income securities
Annualized weekly returns on the bootstrapped zero coupon fixed income securities of maturities
from 0.5 to 10 years (20 issues) are obtained for the period from 1988/01/04 to 2004/12/31 by
converting daily bootstrapping zero coupon yields into weekly returns. The following technique is
used for the return calculation: first Friday prices of the securities are calculated; then the returns
are calculated as annualized growth rates of the price for each week. Totally 886 observations
are obtained. Std.Dev. stands for standard deviation, Rho (1), Rho (2), Rho (3) for
autocorrelations at lags 1, 2 and 3 weeks, respectively.

Maturity Excess
Mean Std. Dev. Skewness Rho (1) Rho (2) Rho (3)
(years) kurtosis
0.5 0.0014 0.0279 0.4541 4.1611 0.1080 0.0739 0.1621
1 0.0028 0.0676 0.0265 1.6854 0.0577 0.0687 0.1501
1.5 0.0045 0.1124 -0.1220 1.1257 0.0207 0.0512 0.1297
2 0.0062 0.1559 -0.1843 0.9498 -0.0054 0.0525 0.1116
2.5 0.0080 0.1981 -0.2215 0.8988 -0.0255 0.0554 0.0970
3 0.0099 0.2389 -0.2470 0.8853 -0.0409 0.0577 0.0842
3.5 0.0117 0.2783 -0.2685 0.8987 -0.0527 0.0590 0.0727
4 0.0136 0.3167 -0.2880 0.9323 -0.0616 0.0593 0.0627
4.5 0.0155 0.3540 -0.3058 0.9798 -0.0683 0.0588 0.0541
5 0.0173 0.3905 -0.3218 1.0317 -0.0731 0.0577 0.0468
5.5 0.0192 0.4261 -0.3354 1.0808 -0.0766 0.0563 0.0408
6 0.0211 0.4611 -0.3465 1.1221 -0.0791 0.0545 0.0358
6.5 0.0230 0.4954 -0.3549 1.1525 -0.0807 0.0525 0.0319
7 0.0249 0.5292 -0.3603 1.1710 -0.0819 0.0505 0.0288
7.5 0.0267 0.5626 -0.3630 1.1771 -0.0825 0.0485 0.0265
8 0.0286 0.5958 -0.3627 1.1716 -0.0827 0.0465 0.0248
8.5 0.0305 0.6288 -0.3594 1.1539 -0.0828 0.0446 0.0235
9 0.0324 0.6618 -0.3530 1.1252 -0.0827 0.0427 0.0226
9.5 0.0343 0.6952 -0.3433 1.0845 -0.0825 0.0410 0.0218
10 0.0362 0.7292 -0.3301 1.0313 -0.0826 0.0395 0.0210

24
Figure 1 Annualized weekly returns on the fixed income securities
Panel A: US Treasury securities

3~ us It'eiUlury Bill 6-month US 1l'easury Bill

~
~ ~
~ ~
~ ; - !~ "
~
; ~ ! ~ ~ i ~ i

1.,.., US lreasuryBIII 2-)8.r US li'easury Bond

.. ~
0.25
0.15
0.05
- - - - -. -. _. - . - . - - - - - -- -
-- - - -- -- --- -
- - - - - - - -- - - - - - - - - - - - - - - - - - - --
- - -- - - - -
-
- - -.- . . . . . _.
- -
- - - - - - - --
- ---
:.:~
0.00

~.~~
-050 - -- - -- - - - - - _. - _ .. - - - . _. - - - - - - - - - - - - - - - - - - - - - - - - - - --

·1.00

. ! ~
~

~
~
~ ~
g
~
~
; ;
~
; i ;
~ ::iN
; ; ~ ~ i
~
~ ; ;
~ j !
~
;
" ..::i
~
; ; i!; :; ;;
~ ~

3-)8.r US lteasuryBond 5.,.., US 'lteasury aond

'50~----------------------------------------------------.

1.00· - - - -- - - - - - - - _. - - - - - - - - - --- - -- - - - - -- - - - - - - - -- --

O.SO - - -- -- - - - --

0.00

;;
:::~
~ ! _ _ i;ft~
~
~ ~~ ~...-.~' ~ ~ !~
~
~ ~
~ ~ .. ~ :!~ ~~~",?";
~ ~
,:.9
; ; ; ;" ;" ~ ~ ! ;;;;~;~ ~

7.,.ear US Treasury Bond 10.,.., US 'lteasuryBond

'.'~
1.00 - - -- - -------- - - -- -- -. .. - - --- - - - - - - - -- 13)- - - - - - - - - -. - _. _ .. - - - - - - - - - - - - - - - - - - - - - . - - - .

050 - - . - '100 -- - - -- - - -- - - .-------- . -- - - - _ .

050 -
0.00
0.00
.() 50 - --- ..•

-<150 -
-t 00 --- - - - - - - - - - - _.. _. - - - - . - - - _. - -- -100 -- - - - -- - - - -- - - ------ --- -
-1.50 -150 - - - - - - - - - - - - - --- - - - - - - -. -- -
~ ;; ~ ~ -r ~
~
g ~ iii l • ~ ,
iii i ! I Ii; i i lallal
~ ~

~ ~ ; ; ~ ______________
9 9
; ; ; ; ~ ~ ~ ~ "
-'00

25
 Panel B: Zero coupon fixed income securities (selected maturities)

1.,..r Zero Coupon Bond 2-)18.' Zero Coupon Bond

0.25 1.00

0.50

000

I:: -01S

~~~--~--~~~
~ ~ ~ ~ ~
~
! !
Ii
I ~
! !
i ~ ~
! ! !
g
I

:I
- - - - - - - - - - - - --

--------------l
3-year Zero Coupon Bond 4-)ltar uro Coupon Bond

1'0
1.00
0 50
000

I:~: ,I~ iii

! I ~ !
~
Is
g
~ ~
s I8i
~
----- ------ ------ I
-_ ... _ - - - - - -
5-ye., Zero Coupon Bond 8-y8ar Zero Coupon Bond

~~~
-150 I
~
I !
! !
,
!
I
!
!
!
I
!
I I
! !
·-i -T
! !
I
!
I
~
!
~
g
~~
TI I
"--_.~--- -. . .---

7.,.., Zero Coupon Bond .,..r Zero Coupon Bond

0.50

-0.50

-1.50

~
iii ~ ii
! s~ ! !
~

! ~

9188' Zero Coupon Bond

1.00

0.50

0.00

-0.50

-1.00

g 0 - ,

l _ ~~--

26
Table 2 Eigenvectors and eigenvalues for the fixed income securities returns
The two panels contain the factor loadings (eigenvectors) of the fixed income securities returns
on the first three factors obtained using the Principal Component Analysis. The factors are shown
in the order of decreasing influence on the return variability. For each eigenvector, the
correspondent eigenvalues is presented. % Variance shows the share of the total variability in the
original dataset captured by the factors.

Panel A: US Treasury securities

1st factor
nd
Maturity 2 factor 3rd factor
1 month -0.0074 -0.0584 0.2042
6 months -0.0175 0.1209 -0.4151
1 year -0.0392 0.2125 -0.7414
2 years -0.1727 0.4605 -0.0826
3 years -0.2650 0.5333 0.0260
5 years -0.4170 0.3912 0.2642
7 years -0.5357 -0.0837 0.2560
10 years -0.6612 -0.5294 -0.3057
Eigenvalue 0.7014 0.0157 0.0042
% Variance 96.37% 2.16% 0.58%
Panel B: Zero coupon fixed income securities
Maturity (years) 1st factor 2
nd
factor
rd
3 factor
0.5 -0.0094 -0.0419 0.0764
1 -0.0274 -0.1048 0.1946
1.5 -0.0483 -0.1706 0.2969
2 -0.0698 -0.2248 0.3361
2.5 -0.0913 -0.2654 0.3188
3 -0.1126 -0.2913 0.2589
3.5 -0.1335 -0.3025 0.1723
4 -0.1540 -0.2997 0.0739
4.5 -0.1739 -0.2840 -0.0244
5 -0.1933 -0.2566 -0.1133
5.5 -0.2122 -0.2188 -0.1856
6 -0.2305 -0.1721 -0.2362
6.5 -0.2484 -0.1176 -0.2614
7 -0.2659 -0.0567 -0.2588
7.5 -0.2829 0.0096 -0.2262
8 -0.2995 0.0803 -0.1623
8.5 -0.3157 0.1543 -0.0664
9 -0.3316 0.2308 0.0623
9.5 -0.3472 0.3091 0.2244
10 -0.3624 0.3884 0.4198
Eigenvalue 3.9476 0.0728 0.0113
% Variance 97.86% 1.80% 0.28%

27
Figure 2 Factor loadings of the fixed income securities returns
The two panels plot the factor loadings of the fixed income securities returns on the first three
factors obtained using the Principal Component Analysis.

Panel A: US Treasury securities

--+-1 st factor
-------- --- --- ---

_2nd factor
0.4 - . - 3d factor

0.2 ~

o --
-0.2

-0.4

-0.6

-0.8

-1 -l-----..~--~
1 rronth 6 rronth 1 year 2 years 3 years 5 years 7 years 10 years

- - . _ - _ .. _ _.
Maturity
- _...• _ - - - - - - - - - - - - - - - - - - - - . - - - - --------
Panel B: Zero coupon fixed income securities

0.50
-+- 1st factor
---·-----1
--- ----_.

---4- 2nd factor

0.40
---.- 3d factor
0.30
0.20
0.10
0.00
-0.10
-0.20
-0.30
-0.40
-0.50
0.5 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10

1_-- Maturity

28
Table 3 Comparative effectiveness of different immunization methods by the
example of weekly returns on 3-year US Treasury Bonds.
Whenever appropriate, seven different methods of immunization against one, two and three
common factors are implemented to hedge the 3-year U.S. Treasury security. To estimate and
compare the effectiveness of the hedging methods, both rolling window and expanding window
approaches are used. For rolling window analysis, 10-year period, which includes 520
observations, is chosen. Totally, 804 rolling windows are obtained by rolling forward by week
intervals. In expanding window analysis, the first window corresponds to 10-year period (520
observations). Totally, 804 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 19 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SD Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expandin~ Windows

Method Factors
Mean Vol SO Vol Mean Vol SO Vol
Mean-Variance optimization 0.0352 0.0062 0.0454 0.0034
1 0.1268 0.1283 0.1389 0.1287
PCA, Securities Selection:
Random 2 0.2544 1.3364 0.1379 0.1540
3 0.7477 5.2614 0.6801 5.2857
1 0.4907 0.0831 0.4956 0.0082
PCA, Securities Selection:
Minimum Residual Volatility 2 0.2631 0.0563 0.1805 0.0137
3 4.0348 37.7972 81.4587 548.8701
1 0.0869 0.0060 0.0984 0.0039
PCA, Securities Selection:
Butterfly 2 0.2736 0.0474 0.1811 0.0113
3 0.2282 0.0805 0.1499 0.0213
1 0.0677 0.0059 0.0777 0.0035
PCA, Criterion Matrix:
Diagonal Covariance 2 0.0401 0.0054 0.0482 0.0031 I
3 0.0387 0.0073 0.0501 0.0030
1 0.0352 0.0062 0.0454 0.0034
PCA, Criterion Matrix:
Full Covariance 2 0.0357 0.0064 0.0461 0.0035
3 0.0359 0.0063 0.0463 0.0036
1 0.0615 0.0055 0.0713 0.0033
PCA, Criterion Matrix:
Identity 2 0.0434 0.0048 0.0510 0.0028
3 0.0421 0.0057 0.0507 0.0033
Unhedaed 0.2122 0.0238 0.2566 0.0148

29
Table 4 Comparative effectiveness of different immunization methods by the example
of weekly returns on 5-year zero coupon fixed income security.
Whenever appropriate, seven different methods of immunization against one, two and three
common factors are implemented to hedge the 5-year zero coupon fixed income security. To
estimate and compare the effectiveness of the hedging methods, both rolling window and
expanding window approaches are used. For rolling window analysis, 10-year period, which
includes 520 observations, is chosen. Totally, 366 rolling windows are obtained by rolling forward
by week intervals. In expanding window analysis, the first window corresponds to 10-year period
(520 observations). Totally, 366 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 19 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SD Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expanding

Windows
Method Factors Mean Vol SO Vol Mean Vol SO Vol
Mean-Variance optimization 0.0001 0.0000 0.0001 0.0000
1 0.0491 0.0414 0.0532 0.0395
PCA, Securities Selection:
2 0.0305 0.0403 0.0974 1.2196
Random
3 0.3125 5.7722 0.0172 0.0713
1 0.0658 0.0050 0.0701 0.0011
PCA, Securities Selection:
2 0.0120 0.0028 0.0135 0.0010
Minimum Residual Volatility
3 0.0029 0.0006 0.0037 0.0001
1 0.1180 0.0103 0.1269 0.0028
PCA, Securities Selection:
2 0.1006 0.0112 0.1160 0.0031
Butterfly
3 0.0634 0.0079 0.0701 0.0026
1 0.0592 0.0050 0.0631 0.0012
PCA, Criterion Matrix:
2 0.0081 0.0004 0.0092 0.0002
Diagonal Covariance
3 0.0071 0.0012 0.0076 0.0005
1 0.0001 0.0000 0.0001 0.0000
PCA. Criterion Matrix:
2 0.0001 0.0000 0.0001 0.0000
Full Covariance
3 0.0001 0.0000 0.0001 0.0000
1 0.0498 0.0048 0.0539 0.0012
PCA, Criterion Matrix:
2 0.0087 0.0008 0.0093 0.0002
Identity
3 0.0084 0.0012 0.0091 0.0004
Unhedged 0.3780 0.0131 0.3800 0.0064

30
Table 5 Comparative effectiveness of different immunization methods by the example
of weekly returns on 1-month US Treasury Bills.
Whenever appropriate, six different methods of immunization against one, two and three common
factors are implemented to hedge the 1-month U.S. Treasury security. To estimate and compare
the effectiveness of the hedging methods, both rolling window and expanding window
approaches are used. For rolling window analysis, 10-year period, which includes 520
observations, is chosen. Totally, 804 rolling windows are obtained by rolling forward by week
intervals. In expanding window analysis, the first window corresponds to 10-year period (520
observations). Totally, 804 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 16 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SD Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expandin~ Windows

Method Factors
Ma;llnVal SDVol Ma;lln Vnl SDVol
Mean-Variance ontlmlzatlon 0.0130 0.0027 0.0177 0.0013
1 0.1022 0.1126 0.1231 0.1213
PCA, Securities Selection:
Random 2 0.1342 0.6635 0.2465 0.7721
3 0.1552 0.5130 0.5481 2.4127
1 0.0149 0.0045 0.0235 0.0021
PCA, Securities Selection:
Minimum Residual Volatility 2 0.0168 0.0043 0.0256 0.0033
3 0.0175 0.0113 0.0200 0.0015
1 0.0226 0.0060 0.0364 0.0035
PCA, Criterion Matrix:
Diagonal Covariance 2 0.0206 0.0052 0.0324 0.0032
3 0.0176 0.0017 0.0203 0.0010
1 0.0130 0.0027 0.0177 0.0013
PCA, Criterion Matrix:
Full Covariance 2 0.0132 0.0028 0.0182 0.0014
3 0.0139 0.0036 0.0197 0.0015
1 0.0426 0.0041 0.0524 0.0027
PCA, Criterion Matrix:
Identity 2 0.0274 0.0057 0.0407 0.0040
3 0.0264 0.0052 0.0390 0.0029
Unhedged 0.0134 0.0038 0.0236 0.0025

31
Table 6 Comparative effectiveness of different immunization methods by the example
of weekly returns on 6-month zero coupon fixed income security.
Whenever appropriate, seven different methods of immunization against one, two and three
common factors are implemented to hedge the 6-month zero coupon fixed income security. To
estimate and compare the effectiveness of the hedging methods, both rolling window and
expanding window approaches are used. For rolling window analysis, 10-year period, which
includes 520 observations, is chosen. Totally, 366 rolling windows are obtained by rolling forward
by week intervals. In expanding window analysis, the first window corresponds to 10-year period
(520 observations). Totally, 366 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 16 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SD Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expanding

Windows
Method Factors Mean Vol SDVol Mean Vol SDVol
Mean-Variance optimization 0.0053 0.0034 0.0116 0.0003
1 0.1629 0.1277 0.1688 0.1207
PCA, Securities Selection:
2 0.1791 0.2601 0.2695 0.3979
Random
3 0.1071 0.1146 0.1019 0.1076
1 0.3142 0.0345 0.3411 0.0103
PCA, Securities Selection:
2 0.3338 0.0965 0.4551 0.0802
Minimum Residual Volatility
3 0.2688 0.1358 0.3977 0.0062
1 0.0654 0.0025 0.0703 0.0013
PCA, Criterion Matrix:
2 0.0488 0.0038 0.0560 0.0014
Diagonal Covariance
3 0.0419 0.0027 0.0470 0.0007
1 0.0053 0.0034 0.0117 0.0003
PCA, Criterion Matrix:
2 0.0053 0.0034 0.0117 0.0003
Full Covariance
3 0.0053 0.0034 0.0119 0.0003
1 0.0948 0.0054 0.1007 0.0013
PCA, Criterion Matrix:
2 0.0511 0.0049 0.0583 0.0013
Identity
3 0.0294 0.0018 0.0322 0.0005
Unhedged 0.0259 0.0023 0.0293 0.0008

32
Table 7 Comparative effectiveness of different immunization methods by the example
of weekly returns on 10-year US Treasury Bonds.
Whenever appropriate, six different methods of immunization against one, two and three common
factors are implemented to hedge the 10-year U.S. Treasury security. To estimate and compare
the effectiveness of the hedging methods, both rolling window and expanding window
approaches are used. For rolling window analysis, 10-year period, which includes 520
observations, is chosen. Totally, 804 rolling windows are obtained by rolling forward by week
intervals. In expanding window analysis, the first window corresponds to 10-year period (520
observations). Totally, 804 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 16 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SO Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expandin~ Windows

Method Factors
Mean Vol SO Vol Mean Vol SO Vol
Mean-Variance optimization 0.0975 0.0065 0.0986 0.0024
1 0.2992 0.3299 0.3245 0.3264
PCA, Securities Selection:
Random 2 1.3049 7.7816 0.4918 0.6178 I
3 4.1771 15.2148 0.7794 1.4178
1 1.3380 0.2830 1.2606 0.0363
PCA, Securities Selection:
Minimum Residual Volatility 2 2.4119 0.9940 0.6907 0.0817
3 31.5127 185.0980 2.5172 0.3554
1 0.1122 0.0074 0.1117 0.0030 '
PCA, Criterion Matrix:
Diagonal Covariance 2 0.1151 0.0118 0.1083 0.0042
3 0.5701 0.5003 0.1198 0.0086
1 0.0979 0.0065 0.0988 0.0025
PCA, Criterion Matrix:
Full Covariance 2 0.1131 0.0118 0.1071 0.0040
3 0.5412 0.4655 0.1174 0.0084
1 0.1165 0.0061 0.1186 0.0032
PCA, Criterion Matrix:
Identity 2 0.1147 0.0121 0.1076 0.0040
3 0.5782 0.5097 0.1179 0.0083
Unhedaed 0.5290 0.0370 0.5929 0.0214

33
Table 8 Comparative effectiveness of different immunization methods by the example
of weekly returns on 20-year zero coupon fixed income security.
Whenever appropriate, seven different methods of immunization against one, two and three
common factors are implemented to hedge the 10-year zero coupon fixed income security. To
estimate and compare the effectiveness of the hedging methods, both rolling window and
expanding window approaches are used. For rolling window analysis, 10-year period, which
includes 520 observations, is chosen. Totally, 366 rolling windows are obtained by rolling forward
by week intervals. In expanding window analysis, the first window corresponds to 1O-year period
(520 observations). Totally, 366 windows are obtained by expanding windows by week intervals.
For each rolling and expanding window, 16 self-financing hedging portfolios are constructed.
Then, the out-of-sample volatilities of the portfolios are calculated. Each out-of-sample interval is
constructed by adding one observation to the sample. The table below represents the mean and
standard deviation of the out-of-sample volatilities (Mean Vol and SO Vol, respectively). PCA
stands for the Principal Component Analysis.

Rolling Windows Expanding

Windows
Method Factors Mean Vol SDVol Mean Vol SDVol
Mean-Variance optimization 0.0005 0.0000 0.0005 0.0000
1 0.1453 0.1012 0.1523 0.1040
PCA, Securities Selection:
2 0.1280 0.3684 0.5258 8.0372
Random
3 0.1329 0.5540 0.1019 0.3380
1 0.1214 0.0147 0.1337 0.0049
PCA, Securities Selection:
2 0.0203 0.0127 0.0163 0.0080
Minimum Residual Volatility
3 0.0030 0.0021 0.0009 0.0000
1 0.1147 0.0136 0.1253 0.0046
PCA, Criterion Matrix:
2 0.0470 0.0067 0.0526 0.0022
Diagonal Covariance
3 0.0130 0.0011 0.0141 0.0003
1 0.0005 0.0000 0.0005 0.0000
PCA, Criterion Matrix:
2 0.0005 0.0000 0.0005 0.0000
Full Covariance
3 0.0005 0.0000 0.0005 0.0000
1 0.0973 0.0120 0.1071 0.0039
PCA, Criterion Matrix:
2 0.0540 0.0091 0.0610 0.0033
Identity
3 0.0224 0.0027 0.0241 0.0009
Unhedged 0.7035 0.0318 0.7039 0.0156

34
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