Connor, Gregory and Korajczyk, Robert
A Test for the Number of Factors in an Approximate Factor Model.
The Journal of Finance, 45 (4).
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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