Chapter 3

Principal Component Analysis

Introduction: Goal and Method

The market presents itself to the observer through a surface of incommensurably many data and movements. The links between those data and movements, for example the tendency of two-year (2Y) and 10Y interest rates to rise and fall together, point toward a more or less systematic mechanism hidden in the core of the market. Our goal is to see through the surface of the market and into its structural core.

To do so, we face the problem of finding the right (degree of) formal assumptions about the structure of a market. As an extreme position, if we made no formal assumptions at all, we would remain stuck to the surface of incommensurable market data, unable to understand anything ...

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