We develop a new empirical approach to term structure analysis that allows testing for time-varying risk premiums and arbitrage opportunities in models with both unobservable factors and factors identied as the innovations to observed macroeconomic variables. Factors may play double roles as both covariance-generating common shocks driving yields and determinants of market prices of risk in cross-sectional pricing. The evidence favors time-varying risk prices signicantly related to the second Stock-Watson principal component of macroeconomic variables and to changes in the
industrial production index. Our preferred specication includes these two observable and two unobservable factors, with the no-arbitrage condition imposed.