Canonical Term-Structure Models with Observable Factors and the Dynamics of Bond Risk Premia

We derive a canonical representation for the no-arbitrage discrete-time term structure models with both observable and unobservable state variables, popularized by Ang and Piazzesi (2003). We conduct a specification analysis based on this canonical representation and we analyze how alternative parametrizations affect estimated risk premia, impulse response functions and variance decompositions. We find a trade-off between the need to obtain parsimonious parametrizations and the ability of the models to match observed patterns of variation in risk premia. We also find that more richly parametrized models uncover a greater influence of macroeconomic fundamentals on the long-end of the yield curve