A Model of the Euro-Area Yield-Curve with Discrete Policy Rates

Abstract:     
This paper presents a no-arbitrage model of the yield curve where the central-bank policy rate is explicitly taken into account and that is consistent with the zero-lower-bound restriction. After having estimated the model using daily euro-area data, I explore the behavior of risk premia at the short end of the yield curve. These risk premia are neglected by the widely-used practice that consists in backing out market forecasts of future policy-rate moves from money-market forward rates. My results suggest that this practice is valid in terms of sign of the expected target moves, but that it tends to overestimate their size. As an additional contribution, the model is exploited to simulate forward-guidance measures. A credible commitment of the central bank to keep its policy rate unchanged for a deterministic period of time can result in substantial declines in yields. For instance, a central-bank commitment to keep the policy rate at 1% over the next 2 years would imply a decline in the 5-year rate of about 25 basis points.

Number of Pages in PDF File: 47

Keywords: affine term-structure models, zero lower bound, regime switching, forward policy guidance

JEL Classification: E43, E44, E47, E52, G12

working papers series