Functional principal component analysis

Functional principal component analysis (FPCA) is a statistical method for investigating the dominant modes of variation of functional data. Using this method, a random function is represented in the eigenbasis, which is an orthonormal basis of the Hilbert space L2 that consists of the eigenfunctions of the autocovariance operator. FPCA represents functional data in the most parsimonious way, in the sense that when using a fixed number of basis functions, the eigenfunction basis explains more variation than any other basis expansion. FPCA can be applied for representing random functions, or in functional regression and classification.For a square-integrable stochastic process X(t), t ∈ ?, let The first eigenfunction φ 1 {displaystyle varphi _{1}}   depicts the dominant mode of variation of X. Let Yij = Xi(tij) + εij be the observations made at locations (usually time points) tij, where Xi is the i-th realization of the smooth stochastic process that generates the data, and εij are identically and independently distributed normal random variable with mean 0 and variance σ2, j = 1, 2, ..., mi. To obtain an estimate of the mean function μ(tij), if a dense sample on a regular grid is available, one may take the average at each location tij:FPCA can be applied for displaying the modes of functional variation, in scatterplots of FPCs against each other or of responses against FPCs, for modeling sparse longitudinal data, or for functional regression and classification, e.g., functional linear regression. Scree plots and other methods can be used to determine the number of included components. Functional Principal component analysis has varied applications in time series analysis. Nowadays, this methodology is being adapted from traditional multi-variate techniques to carry out analysis on financial data sets such as stock market indices, generation of implied volatility graphs and so on. A very nice example of the advantages of the functional approach is the Smoothed FPCA (SPCA), proposed by Silverman and studied by Pezzulli and Silverman that enables direct combination of the FPCA analysis together with a general smoothing approach that makes the use of the information stored in some linear differential operators possible. An important application of the FPCA already known from multivariate PCA, is motivated by the Karhunen-Loève decomposition of a random function to the set of functional parameters – factor functions and corresponding factor loadings (scalar random variables). This application is much more important than in the standard multivariate PCA since the distribution of the random function is in general too complex to be directly analyzed and the Karhunen-Loève decomposition reduces the analysis to the interpretation of the factor functions and the distribution of scalar random variables. Due to dimensionality reduction as well as its accuracy to represent data, there is a wide scope for further developments of functional principal component techniques in the financial field.The following table shows a comparison of various elements of principal component analysis (PCA) and FPCA. The two methods are both used for dimensionality reduction. In implementations, FPCA uses a PCA step.