Essays on the Term Structure of Interest Rates
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This dissertation consists of three essays on the term structure of interest rates. In the first essay, I provide evidence on the existence of unspanned macro risk. I investigate the usefulness of unspanned macro information for forecasting bond risk premia in a macro-finance term structure model from the perspective of a bond investor. I account for model uncertainty by combining forecasts with and without unspanned output and inflation risks optimally from the forecaster's objective, and I take advantage of the no-arbitrage condition by imposing risk premium restrictions for the purpose of forecasting. Incorporating macro information generates significant gains in forecasting bond risk premia relative to yield curve information at long forecast horizons, especially when allowing for time-varying combination weight. These gains in predictive accuracy significantly improve investor utility. Cochrane and Piazzesi (2005) and Duffee (2011a) find that information not captured by traditional term structure factors helps predict excess bond returns. The second essay shows that when estimating no-arbitrage affine term structure models, aligning in-sample and out-of-sample objective functions results in term structure factors that capture similar information that remains hidden from existing approaches. Specifically, the estimates of the third term structure factor radically differ. Consistent with Cochrane and Piazzesi (2005), this factor confirms the importance of the fourth principal component of yields for forecasting the term structure. The new objective function leads to substantial improvements in forecasting performance. Model term premiums are higher and expected future short rates are lower. The third essay proposes a no-arbitrage term structure model with a Taylor rule and two macroeconomic variables, real activity growth and inflation, that each contain long-run and short-run components. Variance decompositions and impulse responses indicate that the impact of macroeconomic variables on the term structure differs from existing models. For short maturities, inflation is relatively more important than real activity growth at short forecast horizons. For longer maturity yields, the long-run component of inflation explains most of the long-horizon forecast variance, but real activity growth matters for short forecast horizons. Unlike existing macro models, the model implies plausible term premia and expectations of short rates. The long-run components also improve the prediction of bond excess returns relative to information in the yield curve and macro variables. Measures of in-sample and out-of-sample fit confirm the benefits of allowing for long- and short-run components.