Finance and Economics Discussion Series (FEDS)
March 1999
Short Rate Expectations, Term Premiums, and Central Bank Use of Derivatives to Reduce Policy Uncertainty
P.A. Tinsley
Abstract:
The term structure of interest rates is the primary transmission channel of monetary policy. Under the expectations hypothesis, anticipated settings of the short-term interest rate controlled by the central bank are the main determinants of nominal bond rates. Historical experience suggests that bond rates may remain relatively high even if the short-term interest rate is reduced to zero, in part due to term premiums reflecting uncertainty about future policy. Term spreads due to policy uncertainty may be reduced by central bank trading desk options that provide insurance against future deviations from an announced interest rate policy.
Full paper (472 KB Postscript)Keywords: Bond options, nominal rate zero bound, term premiums
PDF: Full Paper
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