The Yield Curve and Financial Risk Premia ：Implications for Monetary Policy
1 Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 The Macro-Finance Approach to the Analysis
of Monetary Policy and Financial Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Plan of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Part I Theoretical Foundations for Policy Analysis
2 Financial Markets and Asset Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1 Asset Pricing Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1.1 No-Arbitrage and the Stochastic Discount Factor . . . . . . . . . . . . 9
2.1.2 Individual Agent Optimality and Asset Pricing Equations .. . 14
2.1.3 Representative Agent and Equilibrium Asset Pricing . . . . . . . . 18
2.1.4 Asset Returns and a First Look at Risk . . . . . . . . . . . . . . . . . . . . . . . 20
2.2 Asset Pricing with Utility Specifications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.2.1 Agents and Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.2.2 Power Utility and General Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 36
2.2.3 Pitfalls and the CCAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3 The Theory of the Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . 43
3.1 Bond Pricing Representation and Yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.1.1 Notation and Pricing Relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.1.2 Coupon-Bearing Bonds and Duration . . . . . . . . . . . . . . . . . . . . . . . . . 46
3.2 Stylized Facts on the Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
3.2.1 Moments of the US, German and UK Yield Curve .. . . . . . . . . . 49
3.2.2 Common Factors Driving the Yield Curve .. . . . . . . . . . . . . . . . . . . 51
3.3 Fitting Zero-Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3.4 Understanding the Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . 63
3.4.1 A Formal Representation of the Expectations
Hypothesis and No-Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.4.2 Empirical Tests on the Expectations Hypothesis . . . . . . . . . . . . . 68
3.5 Affine Term Structure Representations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.5.1 General Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.5.2 An Essentially Affine Term Structure Model . . . . . . . . . . . . . . . . . 77
4 A Systematic View on Term Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
4.1 Forms and Sources of Term Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
4.2 Evidence on Interest-Rate Risk Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2.1 A Two-Factor Affine Term Structure Model .. . . . . . . . . . . . . . . . . 86
4.2.2 An International Comparison of Essentially
Affine Risk Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
4.3 Compensation for Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.4 Liquidity Risk and Asset Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.4.1 Micro-Finance Approach to Liquidity . . . . . . . . . . . . . . . . . . . . . . . . 106
4.4.2 Liquidity Preference and Uncertainty in Light
of Financial Intermediation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Part II The Term Structure of Interest Rates and Monetary
Policy Rules
5 The Macro-Finance View of the Term Structure of Interest Rates . . . . 117
5.1 On the Use of the Yield Curve for Monetary Policy . . . . . . . . . . . . . . . . . . 117
5.1.1 The Information Content and Its Interpretation.. . . . . . . . . . . . . . 118
5.1.2 Term Structure Reaction to Monetary Policy Events .. . . . . . . . 122
5.1.3 Implementation of Monetary Policy and the Yield Curve.. . . 124
5.2 Joint Modeling Strategies of Interest Rates
and the Macroeconomy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.2.1 The Macro-Finance View of the Term Structure
of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.2.2 VAR-Based Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.2.3 Semi-Structural Macro-FinanceModels . . . . . . . . . . . . . . . . . . . . . . 131
5.2.4 Asset Pricing in a DSGE Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
5.3 Term Structure Implications of New-Keynesian
Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
5.3.1 Stylized Facts and Benchmark Results . . . . . . . . . . . . . . . . . . . . . . . . 135
5.3.2 An Extension: Learning, Volatility and Persistence . . . . . . . . . . 145
6 Monetary Policy in the Presence of Term Structure Effects . . . . . . . . . . . . 159
6.1 The Term Structure of Taylor Coefficients . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
6.2 Incorporating Long-Term Interest Rates into Monetary
Policy Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
6.2.1 Determinacy with Bond Rate Transmission . . . . . . . . . . . . . . . . . . 164
6.2.2 Optimal Simple Rules with Term Structure Information .. . . . 173
6.3 Selected Further Issues on Interest Rates
and the Conduct of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
6.3.1 Policy Inertia: What Does the Term Structure have to Say? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
6.3.2 Monetary Policy Communication and Yield
Curve Reflections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
6.4 Decomposition of the Nominal Yield Curve – BEIRs
and Inflation Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Part III Financial Stability and Monetary Policy
7 Financial Risk and Boom-Bust Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
7.1 Traditional Transmission Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
7.2 The Risk-Taking Channel of Monetary Transmission . . . . . . . . . . . . . . . . 201
7.2.1 Classification and Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
7.2.2 Risk-Taking, Financial Intermediaries
and the Role of the Short-Term Interest Rate . . . . . . . . . . . . . . . . . 203
7.2.3 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
7.3 The Impact of the Monetary Policy Strategy on Risk Tolerance .. . . . 215
7.3.1 Shaping Risk Premia in Monetary Policy Regimes . . . . . . . . . . 215
7.3.2 Optimal Monetary Policy and Bond Risk Premia . . . . . . . . . . . . 219
7.3.3 Risk Premia in the New-Keynesian Model Economy . . . . . . . . 232
7.4 Challenges for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
7.4.1 The Debate on “Too Low for Too Long”
in the Pre-Crisis Period 2002–2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
7.4.2 Financial Intermediaries, the Yield Curve
and Credit Boom-Bust Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.4.3 Macroprudential Policy and Implications
for Central Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
7.4.4 Addressing Financial Instability from a Monetary
Policy Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
8 Conclusion and Outlook .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
A Dynamic Optimization .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
B State-Space Model and Maximum Likelihood Estimation . . . . . . . . . . . . . 273
C Recursive Nature of the Expectations Hypothesis . . . . . . . . . . . . . . . . . . . . . . . 277
D Derivation of Affine Coefficient Loadings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
E Optimal Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289