An Extended Macro-finance Model with Financial Factors
by Hans Dewachter of the University of Leuven & Erasmus University, and
Abstract: This paper extends the benchmark Macro-Finance model by introducing, next to the standard macroeconomic factors, additional liquidity-related and return forecasting factors. Liquidity factors are obtained from a decomposition of the TED spread while the return-forecasting (risk premium) factor is extracted by imposing a single factor structure on the one-period expected excess holding returns. The model is estimated on US data using MCMC techniques. Two findings stand out. First, the model outperforms significantly most structural and nonuctural Macro-Finance yield curve models in terms of cross-sectional ?t of the yield curve. Second, we find that financial shocks, either in the form of liquidity or risk premium shocks, have a statistically and economically significant impact on the yield curve. The impact of financial shocks extends throughout the yield curve but is most pronounced at the high and intermediate frequencies.
Keywords: Yield Curve, Affine Models, Macroeconomics and Financial Factors, Bayesian Estimation.