LIKELIHOOD-BASED SPECIFICATION TESTS FOR DYNAMIC FACTOR MODELS

Abstract

This paper proposes a series of specification tests of the dynamic factor model. The Granger non-causality, linear dependency, and omitted explanatory variables tests are presented. All of the tests can be constructed as a natural byproduct of the routine used to calculate the “smoothed” moments, and they do not require the estimation of additional parameters. The actual size and power of the tests are examined in Monte Carlo experiments. The tests are applied to the term structure model of a yield curve.