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Determining the number of factors when the number of factors can increase with sample size

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  • Li, Hongjun
  • Li, Qi
  • Shi, Yutang

Abstract

Correctly specifying the number of factors (r) is a fundamental issue for the application of factor models. In this paper we develop an econometric method to estimate the number of factors in factor models of large dimensions where the number of factors is allowed to increase as the two dimensions, cross-section size (N) and time period (T) increase. Using similar information criteria as proposed by Bai and Ng (2002), we show that the number of factors can be consistently estimated using the criteria. We propose a new procedure that avoids over estimating the number of factors while allowing for one to search for possible number of factors over a wide range of positive integers so that it also avoids underestimation of the number of factors. We conduct Monte-Carlo simulation to investigate the finite sample properties of the proposed approach.

Suggested Citation

  • Li, Hongjun & Li, Qi & Shi, Yutang, 2017. "Determining the number of factors when the number of factors can increase with sample size," Journal of Econometrics, Elsevier, vol. 197(1), pages 76-86.
    • Handle: RePEc:eee:econom:v:197:y:2017:i:1:p:76-86
    DOI: 10.1016/j.jeconom.2016.06.003
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    More about this item

    Keywords

    Principal components; Factor analysis; Increasing number of factors; Information criteria;
    All these keywords.

    JEL classification:

    • C2 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables
    • C3 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • G1 - Financial Economics - - General Financial Markets

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