Analysis and strategies for managing interest rate risk in North American markets

This paper presents a strategy for estimating the factors driving the Canadian and US term structures of interest rates using principal component analysis. I also estimate the factors for a combination of the US and Canadian term structures. I find that the factors are stable through time when using various overlapping and non-overlapping sub-periods. These factors pertain to the level, steepness and curvature effects of the yield curve. This research has applications in immunization and liability management as it provides evidence that US fixed income securities can be used to partially offset Canadian denominated liabilities and principal components can be used rather than bond durations when analysing and matching exposures. I also model forecasted weekly factor volatility against weekly absolute factor changes using a GARCH(1,1) model. The results are promising as the GARCH model does provide some insight into actual volatility. This has important implications for the risk management of interest sensitive securities as it provides an alternative to value at risk models and other scenario analysis techniques.