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Market Anticipation of Fed Policy Changes and the Term Structure of Interest Rates

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  • Massoud Heidari
  • Liuren Wu

Abstract

The Federal Reserve adjusts the federal funds target rate discretely, causing discontinuity in short-term interest rates. Unlike Poisson jumps, these adjustments are well anticipated by the market. We propose a term structure model that incorporates an anticipated jump component with known arrival times but random jump size. We find that doing so improves the model performance in capturing the term structure behavior. The mean jump sizes extracted from the term structure match the realized target rate changes well. Specification analysis indicates that the jump sizes show strong serial dependence and dependence on the interest-rate factors. Copyright 2010, Oxford University Press.

Suggested Citation

  • Massoud Heidari & Liuren Wu, 2010. "Market Anticipation of Fed Policy Changes and the Term Structure of Interest Rates," Review of Finance, European Finance Association, vol. 14(2), pages 313-342.
    • Handle: RePEc:oup:revfin:v:14:y:2010:i:2:p:313-342
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    File URL: http://hdl.handle.net/10.1093/rof/rfp001
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    Cited by:

    1. Beliaeva, Natalia & Nawalkha, Sanjay, 2012. "Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models," Journal of Banking & Finance, Elsevier, vol. 36(1), pages 151-163.
    2. Paulo Maio, 2014. "Another Look at the Stock Return Response to Monetary Policy Actions," Review of Finance, European Finance Association, vol. 18(1), pages 321-371.
    3. Peter Carr & Liuren Wu, 2023. "Decomposing Long Bond Returns: A Decentralized Theory," Review of Finance, European Finance Association, vol. 27(3), pages 997-1026.
    4. Peter Christoffersen & Christian Dorion & Kris Jacobs & Lotfi Karoui, 2014. "Nonlinear Kalman Filtering in Affine Term Structure Models," Management Science, INFORMS, vol. 60(9), pages 2248-2268, September.
    5. Qian Li & Li Wang, 2023. "Option pricing under jump diffusion model," Papers 2305.10678, arXiv.org.

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