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On determination of the number of factors in an approximate factor model

Author

Listed:
  • Liu Jinshan

    (School of Financial Mathematics and Statistics, Guangdong University of Finance, Guangzhou, 510521, China)

  • Pan Jiazhu

    (Department of Mathematics & Statistics, University of Strathclyde, Glasgow, G1 1XH, UK)

  • Xia Qiang
  • Xiao Li

    (College of Mathematics and Informatics, South China Agricultural University, Guangzhou, 510642, China)

Abstract

This paper proposes a ridge-type method for determining the number of factors in an approximate factor model. The new estimator of factor number is obtained by maximizing both the ratio of two adjacent eigenvalues and the cumulative contribution rate of the factors which represents the explanatory power of the common factors for response variables. Our estimator is proved to be as asymptotically consistent as those in (Ahn, S., and A. Horenstein. 2013. “Eigenvalue Ratio Test for the Number of Factors.” Econometrica 81: 1203–27). But Monte Carlo simulation experiments show our method has better correct selection rates in finite sample cases. A real data example is given for illustration.

Suggested Citation

  • Liu Jinshan & Pan Jiazhu & Xia Qiang & Xiao Li, 2023. "On determination of the number of factors in an approximate factor model," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 27(3), pages 285-298, June.
    • Handle: RePEc:bpj:sndecm:v:27:y:2023:i:3:p:285-298:n:8
    DOI: 10.1515/snde-2020-0055
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    More about this item

    Keywords

    approximate factor model; cumulative contribution rate; eigenvalue ratio; number of factors; ridge-type method;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C3 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables

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