Why Gaussian Macro-Finance Term Structure Models are (Nearly) Unconstrained Factor-VARs

38 Pages Posted: 18 Mar 2011

See all articles by Scott Joslin

Scott Joslin

University of Southern California - Department of Finance and Business Economics

Anh Le

Penn State University Smeal College of Business

Kenneth J. Singleton

Stanford University - Graduate School of Business

Date Written: March 11, 2011

Abstract

This paper explores the impact of simultaneously enforcing the no-arbitrage structure of a Gaussian macro-finance term structure model (MTSM) and accommodating measurement errors on bond yield through filtering on the maximum likelihood estimates of the model-implied conditional distributions of the macro risk factors and bond yields. For the typical yield curves and macro variables studied in this literature, the estimated joint distribution within a canonical MTSM is nearly identical to the estimate from an economic-model-free factor vector-autoregression (factor-VAR), even when measurement errors are large. It follows that a canonical MTSM does not offer any new insights into economic questions regarding the historical distribution of the macro risk factors and yields, over and above what is learned from a factor-VAR. In particular, the discipline of a canonical MTSM is empirically inconsequential for analyses of impulse response functions of bond yields and macro factors or empirical studies of term premiums. These results are rotation-invariant and, therefore, apply to many of the specifications of risk factors in the literature. In deriving these results we develop a new canonical form for MTSMs that is particularly revealing about the nature of the over-identifying restrictions implied by MTSMs relative to yield-based factor models.

Keywords: No-Arbitrage, Gaussian Macro-Finance Term Structure Models

JEL Classification: E43

Suggested Citation

Joslin, Scott and Le, Anh and Singleton, Kenneth J., Why Gaussian Macro-Finance Term Structure Models are (Nearly) Unconstrained Factor-VARs (March 11, 2011). Available at SSRN: https://ssrn.com/abstract=1786617 or http://dx.doi.org/10.2139/ssrn.1786617

Scott Joslin

University of Southern California - Department of Finance and Business Economics ( email )

CA
United States

Anh Le (Contact Author)

Penn State University Smeal College of Business ( email )

Business Building
University Park, PA 16801
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Kenneth J. Singleton

Stanford University - Graduate School of Business ( email )

Knight Management Center
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Stanford, CA 94305-7298
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650-723-5753 (Phone)

HOME PAGE: http://www.stanford.edu/~kenneths

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