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The Target Rate and Term Structure of Interest Rates

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Abstract

This paper presents a tractable bond valuation model, which further develops the approach proposed by Piazzesi (2005). The short term inter-bank interest rate is equal to the target rate set by the central bank plus a spread. Bond yields are driven by the intensities that determine the probabilities that the central bank may raise or cut the target interest rate. Unlike in Piazzesi (2005), negative intensities have a convenient interpretation and do not complicate estimation, and two accurate approximations to the bond pricing equation provide new closed form solutions for discount bond prices that require no numerical integration. Unlike in Piazzesi the target interest rate can be constrained to be non-negative. Yields, especially long term ones, decrease when the central bank is expected to decide more frequent and/or larger average future changes in the target interest rate. The model lends itself to easy calibration and estimation.

Suggested Citation

  • Marco Realdon, 2006. "The Target Rate and Term Structure of Interest Rates," Discussion Papers 06/15, Department of Economics, University of York.
  • Handle: RePEc:yor:yorken:06/15
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    References listed on IDEAS

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    1. Christian Gourieroux & Alain Monfort & Vassilis Polimenis, 2002. "Affine Term Structure Models," Working Papers 2002-49, Center for Research in Economics and Statistics.
    2. Qiang Dai & Kenneth Singleton, 2003. "Term Structure Dynamics in Theory and Reality," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 631-678, July.
    3. Monika Piazzesi, 2005. "Bond Yields and the Federal Reserve," Journal of Political Economy, University of Chicago Press, vol. 113(2), pages 311-344, April.
    4. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
    5. Sun, Licheng, 2005. "Regime shifts in interest rate volatility," Journal of Empirical Finance, Elsevier, vol. 12(3), pages 418-434, June.
    6. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    7. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
    8. Michael Johannes, 2004. "The Statistical and Economic Role of Jumps in Continuous-Time Interest Rate Models," Journal of Finance, American Finance Association, vol. 59(1), pages 227-260, February.
    9. Sun, Tong-sheng, 1992. "Real and Nominal Interest Rates: A Discrete-Time Model and Its Continuous-Time Limit," Review of Financial Studies, Society for Financial Studies, vol. 5(4), pages 581-611.
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    More about this item

    Keywords

    Bond valuation; target interest rate; closed form solution; yield curve; central banker's meeting;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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