Eigenvalue Ratio Test for the Number of Factors

This paper proposes two new estimators for determining the number of factors (r) in static approximate factor models. We exploit the well-known fact that the r largest eigenvalues of the variance matrix of N response variables grow unboundedly as N increases, while the other eigenvalues remain bounded. The new estimators are obtained simply by maximizing the ratio of two adjacent eigenvalues. Our simulation results provide promising evidence for the two estimators.