Why is the third principal component of the yield curve important: A point of view from reverse stress test on credit portfolio

Abstract

The focus of this study is to analyze the shape of the yield curve on credit portfolios during crises, specifically those that are exposed to both interest rate and credit risks. To achieve this, We utilized a reverse stress test (RST) and macroeconomic measures (such as GDP and U.S risk-free yields) from the period of 1981 to 2014 to estimate mathematical models. We then utilized a Monte Carlo simulation to determine the most likely scenario for the measures if the portfolio value reaches a pre-specified threshold.

The researchers discovered that the shape of the stressed yield curves varied depending on whether or not the third principal component of the yield curve was included in the analysis. They found that stressed credit portfolios with maturities ranging from 0.5 to 3 years exhibited a humped shape on yields within that range when the third principal component was included. As stress levels increased, this humped shape became more pronounced, indicating that the stressed credit portfolio's value was impacted by rising yields.

This study's findings have significant implications for financial institutions as they consider the third principal component in their asset-liability management for portfolios with maturities between 0.5 and 3 years.