Articlebronze2016

Resolving the Spanning Puzzle in Macro-Finance Term Structure Models

87 citations0/0 files storedEuropean Finance Review

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Stochastic processes and financial applications Financial Markets and Investment Strategies Credit Risk and Financial Regulations

Abstract

Abstract Most existing macro-finance term structure models (MTSMs) appear incompatible with regression evidence of unspanned macro risk. This “spanning puzzle” appears to invalidate those models in favor of new unspanned MTSMs. However, our empirical analysis supports the previous spanned models. Using simulations to investigate the spanning implications of MTSMs, we show that a canonical spanned model is consistent with the regression evidence; thus, we resolve the spanning puzzle. In addition, direct likelihood-ratio tests find that the knife-edge restrictions of unspanned models are rejected with high statistical significance, though these restrictions have only small effects on cross-sectional fit and estimated term premia.

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References

1993Discretion versus policy rules in practice 1996Inference When a Nuisance Parameter Is Not Identified Under the Null Hypothesis 2013Handbook of the Economics of Finance 1991Common Factors Affecting Bond Returns 1999Monetary Policy Rules 2003A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables 2005Bond Risk Premia 2013Handbook of Economic Forecasting

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