The Target Rate and Term Structure of Interest Rates

Marco Realdon

Discussion Papers from Department of Economics, University of York

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.

Keywords: Bond valuation; target interest rate; closed form solution; yield curve; central banker's meeting (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Date: 2006-08
New Economics Papers: this item is included in nep-cba, nep-fin, nep-fmk, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:yor:yorken:06/15

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