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A Test for the Number of Factors in an Approximate Factor Model

Gregory Connor and Robert A. Korajczyk
The Journal of Finance
Vol. 48, No. 4 (Sep., 1993), pp. 1263-1291
Published by: Wiley for the American Finance Association
DOI: 10.2307/2329038
Stable URL: http://www.jstor.org/stable/2329038
Page Count: 29
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A Test for the Number of Factors in an Approximate Factor Model
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Abstract

An important issue in applications of multifactor models of asset returns is the appropriate number of factors. Most extant tests for the number of factors are valid only for strict factor models, in which diversifiable returns are uncorrelated across assets. In this paper we develop a test statistic to determine the number of factors in an approximate factor model of asset returns, which does not require that diversifiable components of returns be uncorrelated across assets. We find evidence for one to six pervasive factors in the cross-section of New York Stock Exchange and American Stock Exchange stock returns.

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