3 - Factor-Augmented Regressions and Their Applications to Financial Markets: A Selective Review

Summary

This chapter provides a selective review of the factor-augmented regression (FAR) models, where the factors are usually estimated from a large set of observed data, and then as “generated regressors” enter into the next stage of regression. It begins with an introduction to the large-dimensional factor models and the widely used principal component analysis (PCA) estimator. Then we review FAR models with time series data, the extensions of FAR to some nonlinear models, and the factor-augmented panel regressions. Lastly, we briefly introduce some applications of FAR to financial markets.