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An Extended Macro-finance Model with Financial Factors

by Hans Dewachter of the University of Leuven & Erasmus University, and
Leonardo Iania of the University of Leuven

November 2009

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.

JEL Classification: C11, E44, G12.

Keywords: Yield Curve, Affine Models, Macroeconomics and Financial Factors, Bayesian Estimation.

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