Canonical Term-Structure Models with Observable Factors and the Dynamics of Bond Risk Premia


  • Any views expressed in this article are the authors' and do not necessarily represent those of the Bank of Italy. We are extremely grateful to Fabio Panetta, who encouraged us to undertake this research project, and to an anonymous referee for the many improvements she (he) suggested. We thank for helpful discussion Paolo Angelini, Fabio Fornari, Giuseppe Grande, Marco Protopapa, Glenn Rudebusch, Oreste Tristani, Paolo Zaffaroni, and seminar participants and discussants at the Bank of Italy, at the ECB, at the FFM 2005, EEA-ESEM 2006 and EFA 2006 Conferences and at the IX Quantitative Finance Workshop.


We derive a canonical representation for the no-arbitrage discrete-time term structure models with both observable and unobservable state variables, popularized by Ang and Piazzesi (2003). We conduct a specification analysis based on this canonical representation and we analyze how alternative parameterizations affect estimated risk premia, impulse response functions, and variance decompositions. We find a trade-off between the need to obtain parsimonious parameterizations and the ability of the models to match observed patterns of variation in risk premia. We also find that more richly parameterized models uncover a greater influence of macroeconomic fundamentals on the long-end of the yield curve.