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Recovering market expectations of FOMC rate changes with options on federal funds futures

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Author Info

  • John B. Carlson
  • Ben R. Craig
  • William R. Melick

Abstract

This paper demonstrates how options on federal funds futures, which began trading in March 2003, can be used to recover the implied probability density function (PDF) for future Federal Open Market Committee (FOMC) interest rate outcomes. The discrete nature of the choices made by the FOMC allows for a very straightforward recovery of the implied PDF using ordinary least squares (OLS) estimation. This simple recovery method stands in contrast to the relatively complicated PDF recovery techniques developed for options written on assets such as equities, foreign exchange, or commodity futures where the underlying prices are most appropriately modeled as being drawn from continuous distributions. The OLS estimation is used to recover PDFs for single FOMC meetings as well as PDFs for joint estimation of multiple FOMC meetings, and allows for the imposition of restrictions on the recovered probabilities, both within and across FOMC meetings. Finally, recovered probabilities are used to assess the impact of data releases and Fed communication on the perceived likelihood of actual policy outcomes.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0507.

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Date of creation: 2005
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Handle: RePEc:fip:fedcwp:0507

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Keywords: Federal Open Market Committee ; Monetary policy ; Interest rate futures;

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References

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  1. Glenn D. Rudebusch, 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Working Papers in Applied Economic Theory, Federal Reserve Bank of San Francisco 95-02, Federal Reserve Bank of San Francisco.
  2. Ed Nosal, 2001. "How well does the federal funds futures rate predict the future federal funds rate?," Economic Commentary, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, issue Oct.
  3. Monika Piazzesi & Eric Swanson, 2004. "Future prices as risk-adjusted forecasts of monetary policy," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  4. Robert R. Bliss & Nikolaos Panigirtzoglou, 2004. "Option-Implied Risk Aversion Estimates," Journal of Finance, American Finance Association, American Finance Association, vol. 59(1), pages 407-446, 02.
  5. Stephen Bond & Frank Windmeijer, 2005. "Reliable Inference For Gmm Estimators? Finite Sample Properties Of Alternative Test Procedures In Linear Panel Data Models," Econometric Reviews, Taylor & Francis Journals, Taylor & Francis Journals, vol. 24(1), pages 1-37.
  6. Eric T. Swanson, 2004. "Federal Reserve transparency and financial market forecasts of short-term interest rates," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2004-06, Board of Governors of the Federal Reserve System (U.S.).
  7. Melick, William R. & Thomas, Charles P., 1997. "Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 32(01), pages 91-115, March.
  8. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 51(4), pages 621-51, October.
  9. John C. Robertson & Ellis W. Tallman, 1999. "Improving forecasts of the federal funds rate in a policy model," Working Paper, Federal Reserve Bank of Atlanta 99-3, Federal Reserve Bank of Atlanta.
  10. Ling Hu & Peter C.B. Phillips, 2002. "Nonstationary Discrete Choice," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1364, Cowles Foundation for Research in Economics, Yale University.
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Cited by:
  1. Bo Young Chang & Bruno Feunou, 2013. "Measuring Uncertainty in Monetary Policy Using Implied Volatility and Realized Volatility," Working Papers, Bank of Canada 13-37, Bank of Canada.
  2. John C. Williams, 2009. "Heeding Daedalus: Optimal inflation and the zero lower bound," Working Paper Series, Federal Reserve Bank of San Francisco 2009-23, Federal Reserve Bank of San Francisco.
  3. William R. Emmons & Aeimit K. Lakdawala & Christopher J. Neely, 2006. "What are the odds? option-based forecasts of FOMC target changes," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue Nov, pages 543-562.

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