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Short rate expectations, term premiums, and central bank use of derivatives to reduce policy uncertainty

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Author Info
P. A. Tinsley

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Abstract

The term structure of interest rates is the primary transmission channel of monetary policy. Under the expectations hypothesis, anticipated settings of the short-term interest rate controlled by the central bank are the main determinants of nominal bond rates. Historical experience suggests that bond rates may remain relatively high even if the short-term interest rate is reduced to zero, in part due to term premiums reflecting uncertainty about future policy. Term spreads due to policy uncertainty may be reduced by central bank trading desk options that provide insurance against future deviations from an announced interest rate policy.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-14.

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Date of creation: 1998
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Handle: RePEc:fip:fedgfe:1999-14

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Keywords: Interest rates ; Bonds;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Sharon Kozicki & P.A. Tinsley, 1996. "Moving endpoints and the internal consistency of agents' ex ante forecasts," Finance and Economics Discussion Series 96-47, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  2. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179. [Downloadable!] (restricted)
  3. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September. [Downloadable!] (restricted)
  4. Brenner, Robin J. & Harjes, Richard H. & Kroner, Kenneth F., 1996. "Another Look at Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 85-107, March. [Downloadable!]
  5. Turnbull, Stuart M. & Wakeman, Lee Macdonald, 1991. "A Quick Algorithm for Pricing European Average Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(03), pages 377-389, September. [Downloadable!]
  6. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March. [Downloadable!] (restricted)
  7. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. " Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-30, March. [Downloadable!] (restricted)
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  8. Merton, Robert C., 1995. "Financial innovation and the management and regulation of financial institutions," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 461-481, June. [Downloadable!] (restricted)
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  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December. [Downloadable!] (restricted)
  10. Robert Tetlow & John C. Williams, 1998. "Implementing price stability bands, boundaries and inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  11. Sharon Kozicki & P.A. Tinsley, 1998. "Term structure views of monetary policy," Research Working Paper 98-07, Federal Reserve Bank of Kansas City. [Downloadable!]
  12. Douglas Laxton & Eswar Prasad, 1997. "Possible Effects of European Monetary Union on Switzerland: A Case Study of Policy Dilemmas Caused by Low Inflation and the Nominal Interest Rate Floor," IMF Working Papers 97/23, International Monetary Fund.
  13. Fedenia, Mark & Grammatikos, Theoharry, 1992. "Options Trading and the Bid-Ask Spread of the Underlying Stocks," Journal of Business, University of Chicago Press, vol. 65(3), pages 335-51, July. [Downloadable!] (restricted)
  14. Athanasios Orphanides & Volker Wieland, 1998. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Finance and Economics Discussion Series 1998-35, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  15. Jeffrey C. Fuhrer & Brian F. Madigan, 1997. "Monetary Policy When Interest Rates Are Bounded At Zero," The Review of Economics and Statistics, MIT Press, vol. 79(4), pages 573-585, November. [Downloadable!] (restricted)
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  16. Cecchetti, Stephen G, 1988. "The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates during the Great Depression," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1111-41, December. [Downloadable!] (restricted)
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  17. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September. [Downloadable!] (restricted)
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  18. McCulloch, J Huston, 1975. "The Tax-Adjusted Yield Curve," Journal of Finance, American Finance Association, vol. 30(3), pages 811-30, June. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Paolo Savona & Aurelio Maccario & Chiara Oldani, 2000. "On Monetary Analysis of Derivatives," Open Economies Review, Springer, vol. 11(1), pages 149-175, August. [Downloadable!] (restricted)
  2. repec:bep:maccon:v:6:y:2006:i:1:p:1466-1466 is not listed on IDEAS
  3. Melecky, Ales & Melecky, Martin, 2008. "From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects," MPRA Paper 10844, University Library of Munich, Germany. [Downloadable!]
  4. James Clouse & Dale Henderson & Athanasios Orphanides & David Small & Peter Tinsley, 2000. "Monetary policy when the nominal short-term interest rate is zero," Finance and Economics Discussion Series 2000-51, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  5. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA. [Downloadable!]
  6. repec:bep:mactop:v:3:y:2003:i:1:p:1088-1088 is not listed on IDEAS
  7. Sharon Kozicki & P.A. Tinsley, 2001. "Dynamic specifications in optimizing trend-deviation macro models," Research Working Paper RWP 01-03, Federal Reserve Bank of Kansas City. [Downloadable!]
    Other versions:
  8. Martin Melecky & Diego Rodríguez Palenzuela & Ulf Söderström, 2008. "Inflation Target Transparency and the Macroeconomy," Working Papers Central Bank of Chile 490, Central Bank of Chile. [Downloadable!]
    Other versions:
  9. Sharon Kozicki & P.A. Tinsley, 2002. "Term premia : endogenous constraints on monetary policy," Research Working Paper RWP 02-07, Federal Reserve Bank of Kansas City. [Downloadable!]
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