Bonds of various maturities all trade simultaneously in a well-organized market that appears to preclude opportunities for financial arbitrage. Indeed, the assumption of no arbitrage is central to an enormous literature that is devoted to the empirical analysis of bond pricing and the yield curve. This research has found that almost all movements in the yield curve can be captured in a no-arbitrage framework in which yields are linear functions of a few unobservable or latent factors (e.g., Duffieand Kan 1996, Litterman and Scheinkman 1991, and Dai and Singleton 2000).
However, while these popular affine no-arbitrage models do provide useful statistical descriptions of the term structure, they offer little insight into the economic nature of the underlying latent factors or forces that drive movements in interest rates. To provide such insight, this paper combinesa canonical affine no-arbitrage model of the term structure with a standard macroeconomic model.
The short-term interest rate is a critical point of intersection between the finance and macroeconomic perspectives. From a finance perspective, the short rate is a fundamental building block for rates of other maturities because long yields are risk-adjusted averages of expected future short rates. From a macro perspective, the short rate is a key policy instrument under the direct control of the central bank, which adjusts the rate in order to achieve the economic stabilization goals of monetary policy.
Together, the two perspectives suggest that understanding the manner in which central banks move the short rate in response to fundamental macroeconomic shocks should explain movements in the short end of the yield curve; furthermore, with the consistency between long and short rates enforced by the no-arbitrage assumption, expected future macroeconomic variation should account for movements farther out on the yield curve as well.
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A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy
