A Floating Currency Macro Term Structure Model

Abstract: During the last decade there has been many advances in the field of research focusing on term structure models that include macroeconomic risks. The fact that such risks adds to the predictive power of risk premia is evident. However, there is no such models that includes exchange rate dynamics and accounts for these potentially latent effects on the yield curve. This thesis presents a discussion on term structure models. A concept for pricing bonds on the entire range of maturities. Specifically, we look at the family of term structure models called macro-finance term structure models (MTSM), which takes the standard framework of the standard term structure models and adds sources of macroeconomic risks. Our discussion focuses on the role of the exchange rate dynamics, motivating a formulation that can include it, and investigating to see if it adds any information in describing the bond risk premium. Our vantage point comes from that of the unspanned MTSM, and subsequently modifying it to accommodate for exchange rate effects. We are able to present regression evidence supporting our idea of a latent exchange rate effect in the bond term structure.