The yield curve and financial risk premia. Implications for monetary policy. (Q549280)

The book deals with the determinants of yield curve dynamics, and analyses them in a joint macro-finance framework. Such depiction of the subject allows the author to investigate and discuss the interlinkages between economic activity, the conduct of monetary policy, and the underlying macroeconomic factors of bond price movements. Thus this book is a really interesting and valuable source for all those who are interested in a broad and deep look at the financial side of economy. The structure of the book is clear and allows a reader to easily follow the author's considerations and conclusions. A general view of the subject and the plan of the book are presented in Chapter 1. The remainder of the text is divided into three parts. The first of them provides a reader with basics of term structure modeling and risk analysis. In the second part, the author focuses on the macro-finance view of term structure transmission and monetary policy analysis. The third part discusses the financial stability and enriches considerations by introducing financial intermediaries and financial constraints into the analysis. Chapter 2, the first in Part I, deals with no-arbitrage asset pricing. The notions of the stochastic discount factor and no-arbitrage principle are defined. Next, the author extends the first simple pricing model by introducing an investor characterized by his/her utility function derived from consumption, and addresses the problem of the optimal allocation of wealth between individual current consumption and financial assets. These considerations lead to an Euler equation describing the first-order condition for optimal consumption and portfolio choices, and allowing to link asset price and consumptions. The representative agent and general equilibrium are then discussed. An interesting part of this chapter is the section discussing some pitfalls of the consumption-based CAPM (CCAPM). The ideas presented in Chapter 2 are applied in Chapter 3 which contains an overview of models for term structure. After presenting the introductory information concerning bond pricing, yields and duration, the author presents some stylized facts on the yield curve using the US, UK and German data. Next, the problems of modeling the term structure of interest rates in practice are addressed, and the Expectation Hypothesis of the term structure is discussed in theoretical and empirical (tests) framework. The chapter continues with the considerations on affine term structure representations, and ends with introducing a model describing bond yields as an affine function of some state variables within a financial factor model. Chapter 4 presents a systematic view on the sources of risk premia. Forms and sources of term premia are discussed on the basis of literature data. The considerations are supported by empirical analysis. The affine term structure representation for the USA, UK and Germany on government bond securities is applied to extract interest-rate risk from the evolution of the yield curve. Next, the default risk is discussed on the basis of government bond dynamics within the euro area. The chapter ends with the concept of liquidity risk. The difference between market liquidity and funding liquidity is discussed. A simple, stylized model of liquidity crisis is presented in which a reinforcing loop process of falling market and funding liquidity promotes a market environment of suddenly disappearing liquidity. Part II starts with Chapter 5 presenting the macro-finance view of the term structure of interest rates. In this chapter, the author first demonstrates how the yield curve can be exploited to assess the efficacy of monetary policy. Next, the possibilities of joint modeling of interest rates and macroeconomic processes are discussed (VAR-based models, DSGE models). Subsequently, the affine bond yield representation is applied to the New-Keynesian model economy, what allows to draw conclusions about sources of the movements of long-term interest rates and about the possible shapes of the yield curve. The model is then extended by withdrawing the rational expectations paradigm and introducing an imperfect information framework, where agents form expectations in an adaptive learning process and the pricing of bond securities is based on subjective beliefs about the state of the economy. Chapter 6 develops further the ideas from the previous one. The question of whether monetary policy is advised to directly react on bond yield information in a rule-based, short term interest rate setting, is considered in the framework of a model analysis of determinacy of bond rate transmission. The effects of monetary policy communication on the dynamics of the yield curve are also discussed. In particular, the author shows how the yield curve reacts to various communication channels and central bank announcements. In the last part of the chapter, the comparison of nominal and real interest rates is presented. It allows to assess to what extent the nominal term premium variation is caused by inflationary risk. Part III includes the only Chapter 7 that analyzes how monetary policy influences risk perceptions and risk tolerance. Among the applied methodological tools there appears the New-Keynesian model augmented by risk premia, rules of risk management practices and insights of the theory of financial intermediation. The chapter ends with a discussion on the instruments a central bank can use to cope with evolving financial imbalances, and on the usefulness of macro-prudential regulations as a tool for ensuring financial stability. Chapter 8 concludes the book. It contains a summary of the main results and some suggestions for further research. The extensive references and a thorough literature review are an unquestionable advantage of the book. Summarizing, I value this book very highly. It is well written and in a clear way presents both the theoretical and empirical approach to the topic. The author focuses on the financial and economical aspects of the subject but the presented considerations are characterized by quite a high level of mathematical precision. This book, however, is not intended to present mathematics of the yield curve but to explain the financial and economic phenomena of it. Thereby, it can be a useful source for all those determined to understand the reality beyond the mathematical models of term structure.