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Efficient Estimation of Approximate Factor Models

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  • Bai, Jushan
  • Liao, Yuan

Abstract

We study the estimation of a high dimensional approximate factor model in the presence of both cross sectional dependence and heteroskedasticity. The classical method of principal components analysis (PCA) does not efficiently estimate the factor loadings or common factors because it essentially treats the idiosyncratic error to be homoskedastic and cross sectionally uncorrelated. For the efficient estimation, it is essential to estimate a large error covariance matrix. We assume the model to be conditionally sparse, and propose two approaches to estimating the common factors and factor loadings; both are based on maximizing a Gaussian quasi-likelihood and involve regularizing a large covariance sparse matrix. In the first approach the factor loadings and the error covariance are estimated separately while in the second approach they are estimated jointly. Extensive asymptotic analysis has been carried out. In particular, we develop the inferential theory for the two-step estimation. Because the proposed approaches take into account the large error covariance matrix, they produce more efficient estimators than the classical PCA methods or methods based on a strict factor model.

Suggested Citation

  • Bai, Jushan & Liao, Yuan, 2012. "Efficient Estimation of Approximate Factor Models," MPRA Paper 41558, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:41558
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    File URL: https://mpra.ub.uni-muenchen.de/41641/1/MPRA_paper_41641.pdf
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    References listed on IDEAS

    as
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    Cited by:

    1. Matteo Barigozzi & Christian T. Brownlees, 2013. "Nets: Network estimation for time series," Economics Working Papers 1391, Department of Economics and Business, Universitat Pompeu Fabra.
    2. Xu Cheng & Zhipeng Liao & Frank Schorfheide, 2016. "Shrinkage Estimation of High-Dimensional Factor Models with Structural Instabilities," Review of Economic Studies, Oxford University Press, vol. 83(4), pages 1511-1543.
    3. Fan, Jianqing & Han, Fang & Liu, Han & Vickers, Byron, 2016. "Robust inference of risks of large portfolios," Journal of Econometrics, Elsevier, vol. 194(2), pages 298-308.

    More about this item

    Keywords

    High dimensionality; unknown factors; principal components; sparse matrix; conditional sparse; thresholding; cross-sectional correlation; penalized maximum likelihood; adaptive lasso; heteroskedasticity;

    JEL classification:

    • C31 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models; Quantile Regressions; Social Interaction Models
    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • C01 - Mathematical and Quantitative Methods - - General - - - Econometrics

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