Tests for Parameter Instability in Dynamic Factor Models

67 Pages Posted: 23 Aug 2013 Last revised: 13 Mar 2014

See all articles by Xu Han

Xu Han

City University of Hong Kong (CityU) - Department of Economics & Finance

Atsushi Inoue

Southern Methodist University

Date Written: March 12, 2014

Abstract

We develop tests for structural breaks of factor loadings in dynamic factor models. We focus on the joint null hypothesis that all factor loadings are constant over time. Because the number of factor loading parameters goes to infinity as the sample size grows, conventional tests cannot be used. Based on the fact that the presence of a structural change in factor loadings yields a structural change in second moments of factors obtained from the full sample principal component estimation, we reduce the infinite-dimensional problem into a finite-dimensional one and our statistic compares the pre- and post-break subsample second moments of estimated factors. Our test is consistent under the alternative hypothesis in which a fraction of or all factor loadings have structural changes. The Monte Carlo results show that our test has good finite-sample size and power.

Keywords: factor models, structural break

JEL Classification: C12, C33

Suggested Citation

Han, Xu and Inoue, Atsushi, Tests for Parameter Instability in Dynamic Factor Models (March 12, 2014). Available at SSRN: https://ssrn.com/abstract=2314338 or http://dx.doi.org/10.2139/ssrn.2314338

Xu Han (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Atsushi Inoue

Southern Methodist University ( email )

Dallas, TX 75275
United States

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