Identifying and interpreting the factors in factor models via sparsity : Different approaches Article - 2023

Thomas Despois, Catherine Doz

Thomas Despois, Catherine Doz, « Identifying and interpreting the factors in factor models via sparsity : Different approaches  », Journal of Applied Econometrics, à paraître. ISSN 0883-7252

Abstract

With the usual estimation methods of factor models, the estimated factors are notoriously difficult to interpret, unless their interpretation is imposed via restrictions. This paper considers different methods to identify the factor structure and interpret the factors without imposing their interpretation : sparse PCA and factor rotations. We establish a new consistency result for the factors estimated by sparse PCA. Monte Carlo simulations show that our exploratory methods accurately estimate the factor structure, even in small samples. We also apply them on two standard large datasets about international business cycles and the US economy : for each empirical application, they identify the same factor structure, offering a clear economic interpretation of the estimated factors. These exploratory methods can be useful to justify or complement approaches in which the factor structure is imposed a priori.

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