We demonstrate that characterizing the minimal dimension of the term structure of interest rates is more challenging than currently appreciated. The highly structured polynomial patterns of the factor loadings, which are widely reported and discussed in the literature, reflect local correlations of smooth curves across maturities. We derive analytical expressions for the loadings of cross‐sectionally dependent processes that tend to favor a much lower dimension than the true dimension of the underlying factor space. Numerical examples illustrate the significant economic costs of erroneously committing to a parsimoniously parameterized factor space that is informed by standard metrics of goodness‐of‐fit. Our results apply to other assets with a finite maturity structure.

We study some seemingly anomalous results that arise in possibly misspecified, reduced-rank linear asset-pricing models estimated by the continuously updated generalized method of moments. When a spurious factor (that is, a factor that is uncorrelated with the returns on the test assets) is present, the test for correct model specification has asymptotic power that is equal to the nominal size. In other words, applied researchers will erroneously conclude that the model is correctly specified even when the degree of misspecification is arbitrarily large.The rejection probability of the test for overidentifying restrictions typically decreases further in underidentified models where the dimension of the null space is larger than 1.