Working Paper

Resolving the spanning puzzle in macro-finance term structure models

Abstract: Previous macro-finance term structure models (MTSMs) imply that macroeconomic state variables are spanned by (i.e., perfectly correlated with) model-implied bond yields. However, this theoretical implication appears inconsistent with regressions showing that much macroeconomic variation is unspanned and that the unspanned variation helps forecast excess bond returns and future macroeconomic fluctuations. We resolve this contradiction?or ?spanning puzzle??by reconciling spanned MTSMs with the regression evidence, thus salvaging the previous macro-finance literature. Furthermore, we statistically reject ?unspanned? MTSMs, which are an alternative resolution of the spanning puzzle, and show that their knife-edge restrictions are economically unimportant for determining term premia.

Keywords: monetary policy; yield curve; macro-finance; term structure models; unspanned macro risks;

JEL Classification: E43; E52; E44;

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Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2015-01

Number: 2015-1

Pages: 48 pages