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A Testing Procedure for Determining the Number of Factors in Approximate Factor Models with Large Datasets

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Abstract

The paradigm of a factor model is very appealing and has been used extensively in economic analyses. Underlying the factor model is the idea that a large number of economic variables can be adequately modelled by a small number of indicator variables. Throughout this extensive research activity on large dimensional factor models a major preoccupation has been the development of tools for determining the number of factors needed for modelling. This paper provides builds on the work of Kapetanios (2004) to provide an alternative method to information criteria as a tool for estimating the number of factors in large dimensional factor models. The new method is robust to considerable cross-sectional and temporal dependence. The theoretical properties of the method are explored and an extensive Monte Carlo study is undertaken. Results are favourable for the new method and suggest that it is a reasonable alternative to existing methods.

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  • George Kapetanios, 2005. "A Testing Procedure for Determining the Number of Factors in Approximate Factor Models with Large Datasets," Working Papers 551, Queen Mary University of London, School of Economics and Finance.
  • Handle: RePEc:qmw:qmwecw:wp551
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    File URL: https://www.qmul.ac.uk/sef/media/econ/research/workingpapers/archive/wp551.pdf
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    Cited by:

    1. Otter, Pieter W. & Jacobs, Jan P.A.M., 2006. "On information in static and dynamic factor models," CCSO Working Papers 200605, University of Groningen, CCSO Centre for Economic Research.

    More about this item

    Keywords

    Factor models; Large sample covariance matrix; Maximum eigenvalue;

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models

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