Instrumental Variable Estimation of Factor Models with Possibly Many Variables

Abstract

In this paper, we consider the instrumental variables (IV) estimation of factor models. In the psychometrics literature, although the two-stage least squares (2SLS) estimator is routinely used in IV estimation of factor models, alternative estimators have been proposed in the econometrics literature. Therefore, in this paper, we compare the performance of these alternative IV estimators in the context of factor models. Monte Carlo simulation results reveal that the HLIM/HFUL estimator by Hausman, Newey, Woutesen, Chao and Swanson (2012) outperforms the 2SLS estimator and performs best in many cases.