The Surprise Element: Jumps in Interest Rates

Abstract

That information surprises result in discontinuous interest rates is no surprise to participants in the bond markets. We develop a class of Poisson-Gaussian models of the Fed Funds rate to capture surprise effects, and show that these models offer a good statistical description of short rate behavior, and are useful in understanding many empirical phenomena. Jump (Poisson) processes capture empirical features of the data which would not be captured by Gaussian models, and there is strong evidence that existing Gaussian models would be well-enhanced by jump and ARCH-type processes. The analytical and empirical methods in the paper support many applications, such as testing for Fed intervention effects, which are shown to be an important source of surprise jumps in interest rates. The jump model is shown to mitigate the non-linearity of interest rate drifts, so prevalent in pure-diffusion models.

Day-of-week effects are modelled explicitly, and the jump model provides evidence of bond market overreaction, rejecting the martingale hypothesis for interest rates. Jump models mixed with Markov switching processes predicate that conditioning on regime is important in determining short rate behavior.

Keywords: Jumps, Diffusions, Characteristic functions

JEL Classification: C13, C22