Testing for the Interconnection channel

When modeling a large cross-section of interconnected economies, correctly accounting for all the transmission channels is crucial. The use of local small scale Vector Autoregressive (VAR) models augmented by few common factors, or cross sectional averages, reflecting the importance of cross-border information, represents one of the solutions to avoid the proliferation of parameters in large heterogeneous VARs. The factors are typically extracted as a linear combination of the variables under analysis. Their loadings/weights can be estimated or derived from economic literature, and are usually interpreted as interconnection channels. We propose a novel Likelihood Ratio Test procedure to empirically evaluate the chosen set of weights, and show that testing is fundamental for valid inferences. We exploit the intuition that, if the factors employed are empirically valid, no residual information from the cross-section remains statistically significant. The proposed test is intuitive, easy to implement, and presents very good finite sample properties. In the empirical exercise, we test several interconnection channels for the sovereign bond market in the euro area.