On determination of the number of factors in an approximate factor model

Liu Jinshan, Pan Jiazhu, Xia Qiang () and Xiao Li
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Liu Jinshan: School of Financial Mathematics and Statistics, Guangdong University of Finance, Guangzhou 510521, China
Pan Jiazhu: Department of Mathematics & Statistics, University of Strathclyde, Glasgow G1 1XH, UK
Xia Qiang: College of Mathematics and Informatics, South China Agricultural University, Guangzhou 510642, China
Xiao Li: College of Mathematics and Informatics, South China Agricultural University, Guangzhou 510642, China

Studies in Nonlinear Dynamics & Econometrics, 2023, vol. 27, issue 3, 285-298

Abstract: This paper proposes a ridge-type method for determining the number of factors in an approximate factor model. The new estimator of factor number is obtained by maximizing both the ratio of two adjacent eigenvalues and the cumulative contribution rate of the factors which represents the explanatory power of the common factors for response variables. Our estimator is proved to be as asymptotically consistent as those in (Ahn, S., and A. Horenstein. 2013. “Eigenvalue Ratio Test for the Number of Factors.” Econometrica 81: 1203–27). But Monte Carlo simulation experiments show our method has better correct selection rates in finite sample cases. A real data example is given for illustration.

Keywords: approximate factor model; cumulative contribution rate; eigenvalue ratio; number of factors; ridge-type method (search for similar items in EconPapers)
JEL-codes: C1 C3 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1515/snde-2020-0055

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