Dynamic Factor Correlation Model
Econometrics
2025-03-04 v1 Risk Management
Abstract
We introduce a new dynamic factor correlation model with a novel variation-free parametrization of factor loadings. The model is applicable to high dimensions and can accommodate time-varying correlations, heterogeneous heavy-tailed distributions, and dependent idiosyncratic shocks, such as those observed in returns on stocks in the same subindustry. We apply the model to a "small universe" with 12 asset returns and to a "large universe" with 323 asset returns. The former facilitates a comprehensive empirical analysis and comparisons and the latter demonstrates the flexibility and scalability of the model.
Cite
@article{arxiv.2503.01080,
title = {Dynamic Factor Correlation Model},
author = {Chen Tong and Peter Reinhard Hansen},
journal= {arXiv preprint arXiv:2503.01080},
year = {2025}
}