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Was wondering if anyone had any literature to share on the use of PCA to identify proxies for highly illiquid assets?

Say for example I have sold an option on stock A, an index constituent, and would like to hedge using the index constituent that behaves the most like stock A (+ is also more liquid):

How would I go about finding this stock using PCA?

-Someone recommended I use PCA for this problem but am a little confused about how this should be set up...Any ideas?

Many thanks!

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  • $\begingroup$ Build a simple equity risk model: (1) identify 4 or 5 common factors across all stocks via PCA (2) for each stock identify the loadings on the factors (i.e. 5 numbers) (2) Look at the factor loadings for stock A and find another stock with similar loadings on the factors. $\endgroup$ – Alex C Feb 18 '18 at 4:02

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