Abstract
Volatile markets and economic environments can significantly distort the shape and smoothness of yield curve movements. This study explores the influence of movements in United States interest rates on South African interest rates. This study aims to identify the main underlying movements present in the United States and South African yield curves and to further determine the dominant factors that are responsible for driving South African interest rate movements. The principal settings for the study were the United States and South African markets representing, respectively, a developed and developing market. Principal component analysis was used to discern the major drivers of developing and developed market interest rates. The findings show that the principal component analysis technique is able to effectively classify and quantify the movements of yield curves across both markets in terms of three main factors, namely level, slope and curvature shifts. During certain periods, South African yield curve changes were largely driven by variations in United States interest rates and the rand/dollar exchange rate. Results also demonstrated that a volatile market and economic environment can significantly distort the shape and smoothness of yield curve movements.
Highlights
Explaining the volatility of financial assets has become a crucial part of portfolio management
Fund managers and investors retain a substantial amount of risk when they do not understand the volatility of their assets
The absolute level of the yield curve is generally considered less important to investors than changes of the curve (Baygun, Showers & Cherpelis 2000) as the variations in the yield curve describes the volatility of the bond market
Summary
Explaining the volatility of financial assets has become a crucial part of portfolio management. The absolute level of the yield curve is generally considered less important to investors than changes of the curve (Baygun, Showers & Cherpelis 2000) as the variations in the yield curve describes the volatility of the bond market. This helps to illustrate whether the bond market is a safe investment during certain economic periods (Johnson 2005). Principal component analysis quantitatively describes yield curve variations by determining the percentage of variance each factor contributes in explaining these movements This analysis turns out to be remarkably successful because the technique considers the variability present in the entire data set (Hull 2012). The results obtained are reviewed and discussed in section ‘Analysis’, and section ‘Conclusions and suggestions for future research’ concludes
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