Resolving the Spanning Puzzle in Macro-Finance Term Structure Models

Most existing macro-finance term structure models (MTSMs) appear incompatible with regression evidence of unspanned macro risk. This “spanning puzzle” appears to invalidate those models in favor of new unspanned MTSMs. However, our empirical analysis supports the previous spanned models. Using simulations to investigate the spanning implications of MTSMs, we show that a canonical spanned model is consistent with the regression evidence; thus, we resolve the spanning puzzle. In addition, direct likelihood-ratio tests find that the knife-edge restrictions of unspanned models are rejected with high statistical significance, though these restrictions have only small effects on cross-sectional fit and estimated term premia.

Keywords: yield curve, term structure models, macro-finance, unspanned macro risk, monetary policy

JEL Classification: E43, E44, E52

Suggested Citation: Suggested Citation

Bauer, Michael and Rudebusch, Glenn D., Resolving the Spanning Puzzle in Macro-Finance Term Structure Models (May 12, 2016). Review of Finance, 2016, Available at SSRN: https://ssrn.com/abstract=2518037 or http://dx.doi.org/10.2139/ssrn.2518037