Approximate Factor Models for Functional Time Series

Abstract: We propose a novel approximate factor model tailored for analyzing time-dependent curve data. Our model decomposes such data into two distinct components: a low-dimensional predictable factor component and an unpredictable error term. These components are identified through the autocovariance structure of the underlying functional time series. The model parameters are consistently estimated using the eigencomponents of a cumulative autocovariance operator and an information criterion is proposed to determine the appropriate number of factors. Applications to mortality and yield curve modeling illustrate key advantages of our approach over the widely used functional principal component analysis, as it offers parsimonious structural representations of the underlying dynamics along with gains in out-of-sample forecast performance.