Factor Analysis II Dynamic Factor Models

Summit Consulting, LLC
2013 Summit Consulting, LLC

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reused or resdistributed without permission. www.summitllc.us.
Factor Analysis II: Dynamic
Factor Models
2
Introduction: Recall (Static) Factor Analysis
Factor Analysis II: Dynamic Factor Models
Model: =+
Extraction methods:
Principal components: Find the linear combination that explains the maximum
variance from the Xs. This is the first factor. Then find the next combination that
explains the maximum proportion of the remaining variance and is orthogonal to the
next factor, etc. (proceed until all variance is explained)
Maximum Likelihood Estimation: Find the factors that maximize correlation with
variables; need to assume something about the distribution (usually multivariate
normal)
Estimation:
Predict factors using weighted sum (F
X) or Regression Scoring (F
= X X
X
1
)
Use predicted factors in original regression
3
Extension to Dynamic Setting
This is all for a static case (i.e. we are not considering time
dynamics)
But what if we have data collected over time?
Issue: Data can have hundreds of series, but number of time
observations on each series relatively short.
Big N, small T issue
Solution: (Dynamic) Factor Analysis
Sargent and Sims (1977): two dynamic factors can explain a large fraction of variance
in important U.S. quarterly macroeconomic variables.

4
Dynamic Factor Model
Suppose we want to forecast a variable, y
t
, using observations X
t
, their lags,
and lags of y
t
. The issue, however, is the dimensionality problem discussed
above.
Idea of DFM same as in static case: few factors f
t
drive co-movements of X
t
,
which may have large dimensionality.
Model:
X
t
= L f
t
+ e
t

f
t
= L f
t1
+
t

Assumptions:
E e
t
tk
= 0 for all k
E e
it
e
js
= 0 for all s if i j
Similar to in static case,
i
(L) is the dynamic factor loading for the i
th
series
X
it
.
5
Benefits of DFM
If we know the factors and the distribution of (
) then it
turns out we can make efficient forecasts for
using a regression
of
on lagged factors and lags of
.
We avoid the curse of dimensionality because we can capture
the effect of N variables with only q factors, with q<<N.
The issue, however, is as expected: How do we estimate the
factors?
6
Estimating Factors in DFM
Three approaches:
1. Use MLE and the Kalman Filter
2. Use Principal Components Extraction
3. Use a combination of the two
Can think of these as three generations of approaches, that
have been refined over time.
The pre-historic DFMs of Sargent and Sims (1977) did not
estimate factors (just looked for evidence of dynamic factor
structure and estimate the importance of the factor).

7
First Approach: MLE and the Kalman Filter
Idea: Use the Kalman filter to construct the likelihood function,
estimate the parameters by MLE, and then use the KF and
smoother to obtain efficient estimates of factors.
KF in a nutshell: a linear algorithm that basically uses an updating technique every
period to construct efficient forecasts. Useful when you have unobserved series.
Model is a linear state space model:

Here
= (
,
1
, ,
)
8
Estimation in the First Approach
With some standard assumptions, the model above defines a complete
linear state space model. Can use the KF to compute the likelihood, use
MLE to estimate the parameters and then, given the parameters, use
the KF and smoother to estimate filtered values of

Advantage: This state space formulation can handle data irregularities
(for example, if some series are observed weekly and others monthly)
Ex: Angelini, Banbura and Runstler (2008) use a DFM-model with mixed
monthly and quarterly data to forecast monthly GDP in Euro-area
Disadvantage: The number of parameters will be proportional to N.
Since we usually have a large N in the first place, this method can be
cumbersome in most desired applications involving large systems.
9
Second Approach: Principal Components
Solution to a least-squares problem:
min
1
,,
,
1
)(
=1

This minimization problem turns out to be equivalent to:
max
s. t. N
1
= I
r

The solution to this problem is to set
equal to the eigenvectors

of
corresponding to the r largest eigenvalues.

Then it turns out we can predict the factors as:

=
1

This is just like the principal components estimator in the static
case.
10
Estimation in the Second Approach
The principal components estimator of
is consistent (Stock and

Watson, 2002).
Since in time-series/panel data there is always the potential of
heteroskedasticity/autocorrelation, one can use a generalized
principal components estimator (similar to GLS).
The issue with this estimator is that it only is averaging across
series, not across time. That is, you basically need to do
extraction every period, but the method does not account for
potential dynamics of the series.

11
Third Approach: Combining Principal
Components and State Space Methods
Merge the statistical efficiency of the state space approach with
the convenience of the principal components approach.
Use of the KF allows average across series and time, not just
across series as in PC estimators.
In this way, we can get improvements in the estimates of the
factors.

12
Estimation in Third Approach
Two step procedure: Giannone, Reichlin, and Small (2008); Doz,
Giannone and Reichlin (2006).
1. Estimate factors using principal components (or GPC)
2. Use the estimated factors
to estimate the unknown parameters of the state

space representation.
Second step depends on whether state vector is specified in
terms of the static or dynamic factors.
13
Parameter Estimation in Third Approach: Static
Factors
State space model given by:

Given
, estimate by regressing X on
, use residuals to
estimate univariate autoregressions.
Also estimate by regressing
on lags and use those

residuals to estimate
.
14
Parameter Estimation in Third Approach:
Dynamic Factors
State space model given by:

=
1
+

Note the difference here is that
and its lags explicitly enter the

state vector.
Given estimates
one can estimate via a regression of
on
and the coefficients
via the residuals from that

regression.
Can also estimate by estimating a VAR for
.
15
Estimation in Third Approach
Given that we have these estimated parameters, one can then
compute an improved estimate of
or
(which now invokes

time-series averaging) using the KF and smoother.
Note: can also use these estimated coefficients as starting values for MLE
estimation of the coefficients.

16
Determining the Number of Factors
Static factors: Use scree plot/information criteria (for example,
Bai and Ng (2002)).
Basically use a penalized version of MLE/Principal Components where you compute
the trade-off between the benefit of including an additional factor against the cost
of increased sampling variability from estimating another parameter.
Dynamic factors:
Hallin and Liska (2007)
Bai and Ng (2007)
Amenguel and Watson (2007)
17
Uses of Estimated Factors (Estimated Using Any
of the Three Approaches)
Use in second stage regressions:
Forecasting: Can compute one step ahead and multistep forecasts of
using
factors and their lags.
For multi-step case, can either regress
+
on
and their lags (direct

method), or can first estimate a VAR for
, and then use this VAR in

conjunction with the one-step ahead forecasting equation to iterate forward h
periods (iterated method).
Either direct or iterated method can be better; mixed evidence on this.
Factors as instrumental variables
Kapetanios and Marcellino (2008), Bai and Ng (2010)
18
Stata Application
Stata command: dfactor
New in Stata 11
Uses the MLE approach (first approach)
For PC approach: use the command factor
To my knowledge, no Stata command to estimate factors using
the third approach.
Extensions using the third approach could be done by first
estimating factors using principal components extraction (Stata
command factor) and then re-estimating the factors using
dfactor.
19
Next Steps
Dynamic Factor Models have become quite popular in forecasting
applications over the past 5 years.
However, because PC and MLE are still computationally a little
complex, new methodology has been explored.
One new method (talk about next time): Three-Pass Regression
Filter (3PRF)

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Summit Consulting, LLC

2013 Summit Consulting, LLC

on lagged factors and lags of

equal to the eigenvectors

corresponding to the r largest eigenvalues.

is consistent (Stock and

to estimate the unknown parameters of the state

on lags and use those

and its lags explicitly enter the

one can estimate via a regression of

and the coefficients

via the residuals from that

(which now invokes

and their lags (direct

, and then use this VAR in

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