An Asset Pricing Approach to Testing General Term Structure Models

Abstract

We develop a new empirical approach to term structure analysis that allows testing for time-varying risk premiums and arbitrage opportunities in models with both unobservable factors and factors identified as the innovations to observed macroeconomic variables. Factors may play double roles as both covariance-generating common shocks driving yields and determinants of market prices of risk in cross-sectional pricing. The evidence favors time-varying risk prices significantly related to the second Stock-Watson principal component of macroeconomic variables and to changes in the industrial production index. Our preferred specification includes these two observable and two unobservable factors, with the no-arbitrage condition imposed.

Keywords: Arbitrage, Bond Aging Effect, Dynamic Factor Model, Macroeconomic Conditioning Variables, Nonlinear Drift Restriction, State Space Model, Time-Varying Risk Premia, Yield Curve Model

JEL Classification: G12, C32