Challenges in macro-finance modeling

This article 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. The author classifies macro-finance models into pure latent-factor mod...

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Bibliographic Details
Published in:Review - Federal Reserve Bank of St. Louis 2009-09, Vol.91 (5(2)), p.519-544
Main Author: Kim, Don H
Format: Article
Language:English
Subjects:
Arbitrage
Financial engineering
Hypotheses
Impact analysis
Inflation
Macroeconomics
Mathematical finance
Monetary economics
Research methods
Structural change
Studies
Term structure
Variables
Yield curve
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Summary:This article 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. The author classifies macro-finance models into pure latent-factor models (`internal basis models') and models that have observed macroeconomic variables as state variables (`external basis models') and examines the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macro-economic variables and their potentially adverse effect on the specification of external basis models. The author also discusses the challenge of addressing features such as structural breaks and time-varying inflation uncertainty. Empirical difficulties in the estimation and evaluation of macro-finance models are also discussed in detail. Reprinted by permission of the Federal Reserve Bank of St. Louis
ISSN:0014-9187
2163-4505
DOI:10.20955/r.91.519-544