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State-Varying Factor Models of Large Dimensions

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  • Markus Pelger
  • Ruoxuan Xiong

Abstract

This paper develops an inferential theory for state-varying factor models of large dimensions. Unlike constant factor models, loadings are general functions of some recurrent state process. We develop an estimator for the latent factors and state-varying loadings under a large cross-section and time dimension. Our estimator combines nonparametric methods with principal component analysis. We derive the rate of convergence and limiting normal distribution for the factors, loadings and common components. In addition, we develop a statistical test for a change in the factor structure in different states. We apply the estimator to U.S. Treasury yields and S&P500 stock returns. The systematic factor structure in treasury yields differs in times of booms and recessions as well as in periods of high market volatility. State-varying factors based on the VIX capture significantly more variation and pricing information in individual stocks than constant factor models.

Suggested Citation

  • Markus Pelger & Ruoxuan Xiong, 2018. "State-Varying Factor Models of Large Dimensions," Papers 1807.02248, arXiv.org, revised Apr 2019.
  • Handle: RePEc:arx:papers:1807.02248
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    File URL: http://arxiv.org/pdf/1807.02248
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    References listed on IDEAS

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