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Interest rates as options: assessing the markets' view of the liquidity trap

  • Antulio N. Bomfim
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    Nominal short term interest rates have been low in the United States, so low that some have wondered whether the federal funds rate is likely to hit its lower bound at 0 percent. Such a scenario, which some economists have called the liquidity trap, would imply that the Federal Reserve could no longer lower short-term interest rates to counter any deflationary tendencies in the economy. In this paper, I use an affine term structure model to infer what interest rates tell us about the probability, as assessed by financial market participants, of such an event taking place. I also examine whether U.S. short-term rates have been low enough to distort the shape of the yield curve.

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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 2003-45.

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    Date of creation: 2003
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    Handle: RePEc:fip:fedgfe:2003-45
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    1. Black, Fischer, 1995. " Interest Rates as Options," Journal of Finance, American Finance Association, vol. 50(5), pages 1371-76, December.
    2. Pierluigi Balduzzi & Sanjiv Ranjan Das & Silverio Foresi, 1998. "The Central Tendency: A Second Factor In Bond Yields," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 62-72, February.
    3. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    4. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 115-130, March.
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