Factor models for binary financial data

Researchers are often interested in modeling binary decisions made by firms (e.g., the yes or no decisions to split the shares, initiate a dividend, or acquire another firm) as functions of economy-wide variables (common factors). Although factor models for continuous dependent variables are used widely, the toolkit of a financial researcher does not contain a generally accepted methodology that allows estimating factor models for binary dependent variables. In this paper, we study such a methodology. Using simulations, we identify data characteristics that allow for reliable estimates of factor parameters and conclude that the methodology is appropriate for the panel datasets of the type often used in finance. As an illustration, we use the methodology to address a currently debated issue of common factors in firms’ decisions to split their shares.