The link between factor models and mean reversion
- Basic factor equations, Covariance matrices, Eigenvectors & values
- The theory of PCA
- Advantages of PCA (principal component analysis)
- Overview of factor models
- Computational aspects
Interpretation of the results
- Insights into market mechanisms via the eigenvectors and factors of a PCA
- What drives markets and how?
- How strong are directional impacts on spread trades?
- How markets react to external shocks, e.g. the vol surface to a data release?
Using PCA to understand the driving forces of several markets
- Bond markets: How do directional moves impact the yield curve?
- How steep is the yield curve after taking the yield level into account?
- Credit markets: Decomposing corporate bond price action into a rating factor and a sector factor
- Option markets: Decomposing the vol surface by expiries and underlyings
- Commodity markets: Analysing crack and crush spreads net of the direction
- FX markets: Which currencies tend to move together?
- What drives the relative valuation of these clusters of currencies?
- Equity markets: An analytical basis for pairs trading
Decomposing a market into directional (beta) and non-directional (alpha) factors
- Calculating hedge ratios through PCA
- Trades with a defined factor exposure and hedged against all other factors
- Using PCA to analyse the exposure of trading positions & portfolios
- Using PCA for market reconstruction and forecasting
- Using PCA to screen the market for trading opportunities
- Using PCA for asset selection
Combining the elements into a step-by-step guide for PCA-based analysis and trading:
Potential problems and pitfalls of PCA-based trading
- Correlation of factors during subperiods
- Changing eigenvectors
- How to monitor and address these problems
Using PCA to construct trading strategies
- Scenario analysis: How will the US yield curve to react to a rate hike?
- Screening bond and equity markets for trade ideas
- Analyzing PCA residuals to choose the best instruments to express a view
- Hedging a portfolio via factor immunization
- Constructing pairs trades
- Trading the option vol surface
- Trades between different asset classes