Selecting the Correct Number of Factors in Approximate FactorModels : The Large Panel Case with Group Bridge Estimator

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

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Original languageEnglish
Pages (from-to)359 - 374
Journal / PublicationJournal of Business and Economic Statistics
Volume32
Issue number3
Publication statusPublished - 28 Jul 2014

Abstract

This article proposes a group bridge estimator to select the correct number of factors in approximate factor models. It contributes to the literature on shrinkage estimation and factor models by extending the conventional bridge estimator from a single equation to a large panel context. The proposed estimator can consistently estimate the factor loadings of relevant factors and shrink the loadings of irrelevant factors to zero with a probability approaching one. Hence, it provides a consistent estimate for the number of factors. We also propose an algorithm for the new estimator; Monte Carlo experiments show that our algorithm converges reasonably fast and that our estimator has very good performance in small samples. An empirical example is also presented based on a commonly used U.S. macroeconomic dataset.