Estimating a Large Covariance Matrix in Time-varying Factor Models

Abstract: This paper deals with the time-varying high dimensional covariance matrix estimation. We propose two covariance matrix estimators corresponding with a time-varying approximate factor model and a time-varying approximate characteristic-based factor model, respectively. The models allow the factor loadings, factor covariance matrix, and error covariance matrix to change smoothly over time. We study the rate of convergence of each estimator. Our simulation and empirical study indicate that time-varying covariance matrix estimators generally perform better than time-invariant covariance matrix estimators. Also, if characteristics are available that genuinely explain true loadings, the characteristics can be used to estimate loadings more precisely in finite samples; their helpfulness increases when loadings rapidly change.