SELECTION OF INDEPENDENT FACTOR MODEL IN FINANCE

In finance, factor model is a fundamental model to describe the return generation process. Traditionally, the factors are assumed to be uncorrelated with each other. We argue that independence is a better assumption to factor model from the viewpoint of portfolio mangement. Based on this assumption, we propose the independent factor model. As the factors are independent, construction of the model would be another application of Independent Component Analysis (ICA) in finance. In this paper, we illustrate how we select the factors in the independent factor models. Securities in the Hong Kong market were used in the experiment. Minimum description length (MDL) was used to select the number of factors. We examine four sorting criteria for factor selection. The resultant models were cross-examined by the runs test.

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