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Dynamic Factor Correlation Model

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  • Chen Tong
  • Peter Reinhard Hansen

Abstract

We introduce a new dynamic factor correlation model with a novel variation-free parametrization of factor loadings. The model is applicable to high dimensions and can accommodate time-varying correlations, heterogeneous heavy-tailed distributions, and dependent idiosyncratic shocks, such as those observed in returns on stocks in the same subindustry. We apply the model to a "small universe" with 12 asset returns and to a "large universe" with 323 asset returns. The former facilitates a comprehensive empirical analysis and comparisons and the latter demonstrates the flexibility and scalability of the model.

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  • Chen Tong & Peter Reinhard Hansen, 2025. "Dynamic Factor Correlation Model," Papers 2503.01080, arXiv.org.
    • Handle: RePEc:arx:papers:2503.01080
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