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Standard approaches to building and estimating dynamic term structure models rely on the assumption that yields can serve as the factors. However, the assumption is neither theoretically necessary nor empirically supported. This paper documents that almost half of the variation in bond risk premia cannot be detected using the cross section of yields. Fluctuations in this hidden component have strong forecast power for both future short-term interest rates and excess bond returns. They are also negatively correlated with aggregate economic activity, but macroeconomic variables explain only a small fraction of variation in the hidden factor.
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- Refet S. Gürkaynak & Brian P. Sack & Jonathan H. Wright, 2006.
"The U.S. Treasury yield curve: 1961 to the present,"
Finance and Economics Discussion Series
2006-28, Board of Governors of the Federal Reserve System (U.S.).
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NBER Working Papers
8363, National Bureau of Economic Research, Inc.
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"What Does the Yield Curve Tell us about GDP Growth?,"
NBER Working Papers
10672, National Bureau of Economic Research, Inc.
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- Greg Duffee, 2011. "Forecasting with the term structure: The role of no-arbitrage restrictions," Economics Working Paper Archive 576, The Johns Hopkins University,Department of Economics.
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- Ilan Cooper, 2009. "Time-Varying Risk Premiums and the Output Gap," Review of Financial Studies, Society for Financial Studies, vol. 22(7), pages 2601-2633, July.
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