Avoiding jumps in the rotation matrix of time-varying factor models

Published in Finance Research Letters, 2024

Cheung, Y.L. (2024). "Avoiding jumps in the rotation matrix of time-varying factor models" Finance Research Letters, 105869. doi: 10.1016/j.frl.2024.105869

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Time-varying factor models have gained much popularity in recent years. However, the newly developed local estimator is susceptible to a time-varying rotation matrix that may exhibit jumps. This letter proposes a simple method to avoid the jumps. We show by simulations that the proposed procedure can effectively eliminate jumps in the rotation matrix, leading to a substantially lower mean-square forecasting error.

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