NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

In 2004 all publications will carry a motif taken from the €100 banknote. This paper can be downloaded without charge from

This paper quantifies how variation in real economic activity and inflation in the U.S. influenced the market prices of level, slope, and curvature risks in U.S. Treasury markets. To accomplish this we develop a novel arbitrage-free DT SM in which macroeconomic risks – in particular, real output and inflation risks – impact bond investment decisions separately from information about the shape of the yield curve. Estimates of our preferred macro-DT SM over the twenty-three year period from 1985 through 2007 reveal that unspanned macro risks explained a substantial proportion of the variation in forward terms premiums. Unspanned macro risks accounted for nearly 90 % of the conditional variation in short-dated forward term premiums, with unspanned real economic growth being the key driving factor. Over horizons beyond three years, these effects were entirely attributable to unspanned inflation. Using our model, we also reassess some of Chairman Bernanke’s remarks on the interplay between term premiums, the shape of the yield curve, and macroeconomic activity.

We study the economic sources of stock–bond return comovements and their time variation using a dynamic factor model. We identify the economic factors employing a semistruc-tural regime-switching model for state variables such as interest rates, inflation, the output gap, and cash flow growth. We also view risk aversion, uncertainty about inflation and output, and liquidity proxies as additional potential factors. We find that macroeconomic fundamentals contribute little to explaining stock and bond return correlations but that other factors, especially liquidity proxies, play a more important role. The macro factors are still important in fitting bond return volatility, whereas the “variance premium ” is criti-cal in explaining stock return volatility. However, the factor model primarily fails in fitting covariances. (JEL G11, G12, G14, E43, E44) Stock and bond returns in the United States display an average correlation of about 19 % during the post-1968 period. Shiller and Beltratti (1992) un-derestimate the empirical correlation using a present value with constant dis-count rates, whereas Bekaert, Engstrom, and Grenadier (2005) overestimate it in a consumption-based asset pricing model with stochastic risk aversion. Yet,

Montreal, the CEPR meetings at Gerzensee, Econometric World Congress in London, EFA in Moscow, NYU Stern

This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longer-term interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that long-term interest rates are expectations of future average short-term rates. In this paper, we show that many features of the con…guration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using time-varying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, in‡ation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis.

publications feature a motif taken from the €5 banknote. NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. Acknowledgements We thank the Associate Editor, Refet Gürkaynak, and an anonymous referee for suggestions that significantly improved the paper. We are also grateful to Tobias Adrian, Gianni Amisano, David DeJong, Bartosz Mackowiak, Frank Smets, José Valentim and Jonathan Wright for their very helpful comments on earlier drafts. Falk Bräuning and Carlos Garcia provided excellent research assistance. The views expressed do not necessarily reflect those of the European Central Bank or the Eurosystem. Bekaert gratefully acknowledges financial support from Netspar.

From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25%, yet long-maturity yields and forward rates fell. We consider several possible explanations for this “conundrum. ” The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic and financial market volatility, more predictable monetary policy, and the state of the business cycle.

This paper develops new results for both identification and estimation of Gaussian affine term structure models. In terms of identification, we establish that three popular canonical representations are each, for different reasons, unidentified. We also demonstrate that a failure of local identification can complicate numerical search for the maximum-likelihood estimate when one uses conventional estimation methods. A separate contribution of the paper is the proposal of minimum-chi-square estimation as an alternative to maximum-likelihood estimation. We show that, although it is asymptotically equivalent or sometimes even identical to MLE, it can be much easier to compute. In some cases, MCSE allows the researcher to recognize with certainty whether a given estimate represents a global maximum of the likelihood function and makes feasible the computation of small-sample standard errors.

monetary policy, interest rate risk We especially thank Bob Hodrick for providing detailed comments and valuable suggestions.