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A diagnostic criterion for approximate factor structure

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  • Gagliardini, Patrick
  • Ossola, Elisa
  • Scaillet, Olivier
Abstract
We build a simple diagnostic criterion for approximate factor structure in large panel datasets. Given observable factors, the criterion checks whether the errors are weakly cross-sectionally correlated or share at least one unobservable common factor (interactive effects). A general version allows to determine the number of omitted common factors also for time-varying structures. The empirical analysis runs on ten thousand US stocks from January 1968 to December 2011. For monthly returns, we select time-invariant specifications with at least four financial factors, and a scaled three-factor specification. For quarterly returns, we cannot select macroeconomic models without the market factor.

Suggested Citation

  • Gagliardini, Patrick & Ossola, Elisa & Scaillet, Olivier, 2019. "A diagnostic criterion for approximate factor structure," Journal of Econometrics, Elsevier, vol. 212(2), pages 503-521.
    • Handle: RePEc:eee:econom:v:212:y:2019:i:2:p:503-521
    DOI: 10.1016/j.jeconom.2019.06.001
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    More about this item

    Keywords

    Large panel; Approximate factor model; Asset pricing; Model selection; Interactive fixed effects;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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