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Dynamic Factor Correlations

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TL;DR

This paper introduces a dynamic factor correlation model with a variation-free parametrization inspired by the Fisher transformation, capturing time-varying correlations, heavy tails, and dependent shocks. Applied to asset universes, it reveals substantial variation in loadings and correlations, with improvements over Gaussian benchmarks, especially under heavy-tailed distributions.

Abstract
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ABSTRACT We introduce a dynamic factor correlation model whose core methodological innovation is a variation‐free parametrization of dynamic factor loadings, inspired by the generalized Fisher transformation. The model accommodates time‐varying correlations, heterogeneous heavy tails, and dependent idiosyncratic shocks. Applied to a Small Universe of 12 assets and a Large Universe of 323 stocks, the factor structure induces a sparse idiosyncratic correlation matrix with dependencies concentrated within subindustries, enabling scalability to high dimensions under a sparse block structure. Both factor loadings and correlations vary substantially. Allowing for heterogeneous heavy tails via convolution‐ distributions yields sizable improvements relative to Gaussian and multivariate‐ benchmarks.

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