Risk Premiums in Dynamic Term Structure Models with Unspanned Macro Risks

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. We develop a novel arbitrage-free dynamic term structure model in which bond investment decisions are influenced by real output and inflation risks that are unspanned by (imperfectly correlated with) information about the shape of the Treasury yield curve. Our model reveals that, over the period 1985-2007, these unspanned macro risks accounted for a large portion of the variation in forward terms premiums, and there was pronounced cyclical variation in the market prices of level and slope risks. We compare fitted term premiums for the post-2007 crisis period to those from a model with spanned macro risks, and use our findings to reassess some of Chairman Bernanke's remarks on the interplay between term premiums, the shape of the yield curve, and the macroeconomy