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Resolving the spanning puzzle in macro-finance term structure models

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  • Michael D. Bauer
  • Glenn D. Rudebusch

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.

Suggested Citation

  • Michael D. Bauer & Glenn D. Rudebusch, 2015. "Resolving the spanning puzzle in macro-finance term structure models," Working Paper Series 2015-1, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2015-01
    DOI: 10.24148/wp2015-01
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    More about this item

    Keywords

    yield curves; term structure models; macro-finance; unspanned macro risks; monetary policy;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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