From rotational to scalar invariance: Enhancing identifiability in score-driven factor models

Abstract

We show that, for a certain class of scaling matrices including the commonly used inverse square-root of the conditional Fisher Information, score-driven factor models are identifiable up to a multiplicative scalar constant under very mild restrictions. This result has no analogue in parameter-driven models, as it exploits the different structure of the score-driven factor dynamics. Consequently, score-driven models offer a clear advantage in terms of economic interpretability compared to parameter-driven factor models, which are identifiable only up to orthogonal transformations. Our restrictions are order-invariant and can be generalized to scoredriven factor models with dynamic loadings and nonlinear factor models. We test extensively the identification strategy using simulated and real data. The empirical analysis on financial and macroeconomic data reveals a substantial increase of log-likelihood ratios and significantly improved out-of-sample forecast performance when switching from the classical restrictions adopted in the literature to our more flexible specifications.