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A model of the euro-area yield curve with discrete policy rates

  • Renne, J-P.

This paper presents a no-arbitrage model of the yield curve that explicitly incorporates the central-bank policy rate. After having estimated the model using daily euro-area data, I explore the behaviour of risk premia at the short end of the yield curve. These risk premia are neglected by the widely-used practice that consists in backing out market forecasts of future policy-rate moves from money-market forward rates. The results suggest that this practice is valid in terms of sign of the expected target moves, but that it tends to overestimate their size. As an additional contribution, the model is exploited to simulate forward-guidance measures. A credible commitment of the central bank to keep its policy rate unchanged for a given period of time can result in substantial declines in yields. For instance, a central-bank commitment to keep the policy rate at 1% over the next 2 years would imply a decline in the 5-year rate of about 25 basis points.

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Paper provided by Banque de France in its series Working papers with number 395.

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Length: 51 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:bfr:banfra:395
Contact details of provider: Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/
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