Finance and Economics Discussion Series

Challenges in Macro-Finance Modeling

Don Kim
2008-06

Abstract: This paper discusses various challenges in the specification and implementation of �macro-finance� models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. I classify macro-finance models into pure latent-factor models (�internal basis models�) and models which have observed macroeconomic variables as state variables (�external basis models�), and examine the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macro variables and their potentially adverse effect on the specification of external basis models. I also discuss the challenge of addressing features like structural breaks and time-varying inflation uncertainty. Empirical difficulties in the estimation and evaluation of macro-finance models are also discussed in detail.

Keywords: Yield curve, term structure, unspanned factors, macro-finance