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Factor Analysis

The fact is that some factors are not observable disqualifies

regression and other methods.

Factor analysis is a method for investigating whether a number

of variables of interest Y

1

, Y

2

, , Y

l

, are linearly related to a

smaller number of unobservable factors F

1

, F

2

, , F

k

.

Let us consider an example to explain Factor Analysis.

Example

Example: Students entering a

certain MBA program must take

three required courses in

finance, marketing and business

policy. Let Y

1

, Y

2

, and Y

3

,

respectively, represent a

student's grades in these

courses. The available data

consist of the grades of five

students (in a 10-point

numerical scale above the

passing mark), as shown in

Table

Example

It has been suggested that these grades are functions of two

underlying factors, F1 and F2, tentatively and rather loosely

described as quantitative ability and verbal ability, respectively.

It is assumed that each Y variable is linearly related to these

two factors, as follows:

Explanation

The error terms e

1

, e

2

, and e

3

, serve

to indicate that the hypothesized

relationships are not exact.

In the special vocabulary of factor

analysis, the parameters

ij

are

referred to as loadings. For example,

12

is called the loading of variable Y

1

on factor F

2

.

Quantitative skills should help a

student in finance, but not in

marketing or policy. Verbal skills

should be helpful in marketing or

policy but not in finance. In other

words, it is expected that the loadings

have roughly the following structure:

Explanation

Of course, the zeros in the preceding table are not expected to

be exactly equal to zero. By `0' we mean approximately equal to

zero and by `+' a positive number substantially different from

zero.

It may appear that the loadings can be estimated and the

expectations tested by regressing each Y against the two

factors.

Such an approach, however, is not feasible because the factors

cannot be observed.

An entirely new strategy is required i.e. factor analysis.

Assumptions of FA

A1: The error terms e

i

are independent of one another, and such that

E(e

i

) = 0

Var(e

i

) =

Cov(e

i

,e

j

)=0

A2: The unobservable factors F

j

are independent of one another and of the error terms,

and are such that

E(F

j

) = 0

Var(F

j

) =1

Cov(F

i

,F

j

)=0

Cov(F

i

,e

i

)=0

This means in part that there is no relationship between quantitative and verbal ability.

Local (i.e. conditional independence) given the factor: observed variables are

independent of one another.

Cov( y

i

,y

j

| F ) = 0

Cov(Y,F)=B

Explanation

In more advanced models of factor analysis, the condition that

the factors are independent of one another can be relaxed.

As for the factor means 0 and variances 1, the assumption is

that the factors are standardized.

It is an assumption made for mathematical convenience; since

the factors are not observable, we might as well think of them

as measured in standardized form.

Explanation

Each observable variable is a linear function of independent

factors and error terms, and can be written as

Explanation

The communality of the variable, is the part that is explained by

the common factors F

1

and F

2

.

The specific variance, is the part of the variance of Y

i

that is not

accounted by the common factors.

If the two factors were perfect predictors of grades, then

e

1

= e

2

= e

3

= 0 always, and

1

2

=

2

2

=

3

2

= 0.

Explanation

To calculate the covariance of any two observable variables, Y

i

and Y

j

, we can write

Explanation

We can arrange all the variances and covariances in the form of

the following table:

This table is a theoretical variance covariance matrix.

Explanation

Let us now turn to the available data, and calculate the

observed variance covariance matrix:

Explanation

On the one hand, therefore, we have the observed variances

and covariances of the variables;

On the other, the variances and covariances implied by the

factor model.

If the model's assumptions are true, we should be able to

estimate the loadings

ij

so that the resulting estimates of the

theoretical variances and covariances are close to the observed

ones i.e.

S=BB

+

Problem

FACTOR LOADINGS ARE NOT UNIQUE that is, there exist an infinite

number of sets of values of the

ij

yielding the same theoretical variances

and covariances.

For this reason, factor analysis usually proceeds in two stages.

In the first, one set of loadings

ij

is calculated which yields theoretical

variances and covariances that fit the observed ones as closely as

possible according to a certain criterion.

These loadings, however, may not agree with the prior expectations, or

may not lend themselves to a reasonable interpretation.

Thus, in the second stage, the first loadings are rotated" in an effort to

arrive at another set that fit equally well the observed variances and

covariances, but are more consistent with prior expectations or more easily

interpreted.

Stage 1

By using principal component method, we can calculate

loadings

ij

In this method, fist we find eigenvalues and eigenvectors of

observed variance covariance matrix S or observed correlation

matrix R. where

3

Then the matrix of estimated loadings

ij

is given by:

=

2

Stage 1

For our data eigenvalues are 9.87146 8.00773 0.04081

respectively.

And eigenvectors are:

0.99913 0.00841 0.05788

0.04212 0.79081 0.61062

0.04068 0.61201 0.78981

Stage 1

The solution for our example is

Stage 1

The estimate of the specific variance of Y

i

, is the difference

between the observed variance and estimated communality of

Y

i .

Stage 2

When the first factor solution does not reveal the hypothesized

structure of the loadings, then we use rotation.

The rotation is called orthogonal rotation if the axes are maintained

at right angles.

Varimax: the most commonly used method of rotation. It maximizes

the squared ratio of each factor loading to communality of Y.

Oblique: permits a minor amount of correlation among factors.

However, there is no single popular method of this type of rotations.

It requires considerable expertise.

Determine the Number of Factors

Priori Determination: In our example, it is expected that some

loadings will be close to zero, while others will be positive or

negative and substantially different from zero.

Determination Based on Eigenvalues: Only factors with

Eigenvalues greater than 1.0 are retained.

Determination Based on Percentage of Variance.

Determination Based on Scree Plot: A scree plot is a plot of

the Eigenvalues against the number of factors in order of

extraction. The point at which the scree begins denotes the true

number of factors.

Determine the Number of Factors

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