A Diagnostic Criterion for Approximate Factor Structure

Swiss Finance Institute Research Paper No. 16-51

Published in Journal of Econometrics

85 Pages Posted: 3 Aug 2016 Last revised: 18 Sep 2019

See all articles by Patrick Gagliardini

Patrick Gagliardini

USI Università della Svizzera italiana; Swiss Finance Institute

Elisa Ossola

University of Lugano

O. Scaillet

University of Geneva GSEM and GFRI; Swiss Finance Institute; University of Geneva - Research Center for Statistics

Date Written: January 1, 2018

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.

Keywords: large panel, approximate factor model, asset pricing, model selection, interactive fixed effects

JEL Classification: C12, C13, C23, C51, C52, C58, G12

Suggested Citation

Gagliardini, Patrick and Ossola, Elisa and Scaillet, Olivier, A Diagnostic Criterion for Approximate Factor Structure (January 1, 2018). Published in Journal of Econometrics . Available at SSRN: https://ssrn.com/abstract=2817458 or http://dx.doi.org/10.2139/ssrn.2817458

Patrick Gagliardini (Contact Author)

USI Università della Svizzera italiana ( email )

Via Buffi 13
Lugano, TN 6900
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Elisa Ossola

University of Lugano ( email )

Via Giuseppe Buffi 13
Lugano, Ticino 6900
Switzerland

Olivier Scaillet

University of Geneva GSEM and GFRI ( email )

40 Boulevard du Pont d'Arve
Geneva 4, 1211
Switzerland
+ 41 22 379 88 16 (Phone)
+41 22 389 81 04 (Fax)

HOME PAGE: http://www.scaillet.ch

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva - Research Center for Statistics

Geneva
Switzerland

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