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This tool illustrates the impact of a factor reduction on a correlation matrix.
It serves as a companion to Appendix B.3 of Mathematical Finance.
Your may step through five predefined scenarios.
| Scenario 1 | Scenario 2 | Scenario 3 | Scenario 4 | Scenario 5 |
| Reduction to one factor (trivial). | Reduction to two factors. | Reduction to five factors. | Reduction to two factors starting from a setting of high correlation. | Reduction to five factors starting from a setting of high correlation. |
The scenarios 1-3 give a first impression of what a factor reduction does. Increasing the number of factors we will catch more and more of the original correlation structure. The scenarios 4 and 5 show that for some situations it is sufficient to use one 2 or 3 factors to capture the correlation structure.
© Copyright 2007,2013 Christian P. Fries