Instrumental Variables Inference In A Small-Dimensional Var Model With Dynamic Latent Factors

We study semiparametric inference in a small-dimensional vector autoregressive (VAR) model of order p augmented by unobservable common factors with a dynamic described by a VAR process of order q. This state-space specification is useful to measure separately the direct causality effects and the responses to dynamic common factors. We show that the state-space parameters are identifiable from the autocovariance function of the observed process. We estimate the model by means of a multistep procedure in closed-form, which combines an eigenvalue–eigenvector matrix decomposition and a linear instrumental variable estimation allowing for Hansen–Sargan specification tests. We study the asymptotic and finite-sample properties of the parameter estimators and of rank tests for selecting the number of unobservable factors and VAR orders. In an empirical illustration, we investigate the dynamic common factors and the spillover effects that explain the co-movements among the log daily realized volatilities of four European stock market indices.