We develop a new empirical approach to term structure analysis that allows testing for time-varying risk premia and arbitrage opportunities in models with both unobservable factors and factors identified as the innovations to observed macroeconomic variables. All factors play double roles as both covariance-generating common shocks and determinants of market prices of risk in cross-sectional pricing. The evidence favors time-varying risk prices significantly related to the leading Stock-Watson principal component of macroeconomic variables and to changes in the consumer price index. Absence of arbitrage opportunities is not rejected in our preferred specification with these two observable and two unobservable factors.