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A tractable interest rate model with explicit monetary policy rates

Jean-Paul Renne

European Journal of Operational Research, 2016, vol. 251, issue 3, 873-887

Abstract: This paper proposes a novel interest rate model that presents simple analytical pricing formulas for interest rate-based derivatives, including swaps, futures, swaptions, caps and floors. Exploring the regime-switching feature of Markov chains, the proposed model focuses on discrete changes in the central bank policy rates – the main driver of short-term rate fluctuations. An empirical analysis shows that the proposed model generally outperforms other standard short-term rate models in fitting cross-sections of options prices. Moreover, the explicit nature of policy rates, to some extent, enables the model to infer risk-neutral probabilities of the central-bank rate decisions.

Keywords: Yield curve; Option pricing; Regime switching; Market expectations (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1016/j.ejor.2015.12.014

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Handle: RePEc:eee:ejores:v:251:y:2016:i:3:p:873-887