Litterman and Scheinkman three-factor

Question 1

What are the The Three Factors ?

Answer 1

1. Level – Affects all maturities equally.
2. Steepness (Slope) – Affects short-term rates more than long-term rates.
3. Curvature – Affects mid-term rates relative to short- and long-term rates

Question 2

What is the Level Factor?

Answer 2

This represents a parallel shift in the yield curve.

All interest rates, across all maturities, increase or decrease by the same amount.

Example: If the level factor increases by 50 basis points, short-, medium-, and long-term rates all rise by 50 bps.

✔️ Most important factor (explains majority of yield curve changes).

Question 3

What is the Steepness (Slope) Factor?

Answer 3

This measures the difference between short-term and long-term interest rates.

If the yield curve steepens, short-term rates fall while long-term rates rise.

If the yield curve flattens, short-term rates rise while long-term rates fall.

A steepening yield curve usually happens when the central bank lowers short-term rates, expecting economic expansion.

Question 4

What is the Curvature Factor?

Answer 4

Measures changes in medium-term rates relative to short- and long-term rates.

If the curvature factor increases, medium-term rates rise relative to short and long rates (the curve becomes more “humped”).

If the curvature factor decreases, medium-term rates fall relative to short and long rates.

✔️ Curvature changes are rare but relevant for bond traders managing yield curve risk.