A Generalized Factor Model with Local Factors
Abstract: I extend the theory on factor models by incorporating local factors into the model. Local factors only affect an unknown subset of the observed variables. This implies a continuum of eigenvalues of the covariance matrix, as is commonly observed in applications. I derive which factors are pervasive enough to be economically important and which factors are pervasive enough to be estimable using the common principal component estimator. I then introduce a new class of estimators to determine the number of those relevant factors. Unlike existing estimators, my estimators use not only the eigenvalues of the covariance matrix, but also its eigenvectors. I find strong evidence of local factors in a large panel of US macroeconomic indicators.
File(s): File format is application/pdf https://www.philadelphiafed.org/-/media/frbp/assets/working-papers/2019/wp19-23.pdf
Provider: Federal Reserve Bank of Philadelphia
Part of Series: Working Papers
Publication Date: 2019-04-19
Note: Superseded by Working Paper 21-15