A Generalized Factor Model with Local Factors

47 Pages Posted: 26 Apr 2019 Last revised: 29 Apr 2020

See all articles by Simon Freyaldenhoven

Simon Freyaldenhoven

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Date Written: 2019-04-19

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.

Keywords: high-dimensional data, factor models, weak factors, local factors, sparsity

JEL Classification: C38, C52, C55

Suggested Citation

Freyaldenhoven, Simon, A Generalized Factor Model with Local Factors (2019-04-19). FRB of Philadelphia Working Paper No. 19-23. Available at SSRN: https://ssrn.com/abstract=3378191 or http://dx.doi.org/10.21799/frbp.wp.2019.23

Simon Freyaldenhoven (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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