Monetary Policy and Interest Rate Caps: A Regime-Shift Approach

43 Pages Posted: 27 Jun 2012

See all articles by Geneviève Gauthier

Geneviève Gauthier

HEC Montreal - Department of Decision Sciences; HEC Montreal - Department of Management Sciences

Simon Lalancette

HEC Montreal

René Ferland

University of Quebec at Montreal

Date Written: June 27, 2012

Abstract

In this paper, we derive and empirically test a regime-shifting dynamic term structure model for pricing interest rate caps. The central state variables are the target rate of the Federal Reserve and its latent regime in which it fluctuates. These state variables are driven by a discrete time inhomogeneous Markov chain that captures the timing of FOMC meetings. The Fed Funds rate and the slope of the Libor-swap term structure complete the set of state variables. Their dynamics exhibit regime-shifts based on the latent regime of the target rate in both the physical and risk-neutral measures. The modelling approach for pricing at-the-money cap prices leads to an exponential affine analytical form where the regime-shift risk is priced. Allowing for this feature significantly helps the model to empirically match cap prices. The empirical analysis also indicates that the stable regime where the target rate is frequently at inertia is a state where market operators exhibit a higher level of risk aversion. It is also in this regime that the term structure of the mean Black implied volatilities is the highest and where cap price changes are the most sensitive to jumps in the target rate.

Keywords: Target rate, Regime-shift, Markov chain, Risk-neutral valuation, Option caps

JEL Classification: E44, G12

Suggested Citation

Gauthier, Genevieve and Lalancette, Simon and Ferland, René, Monetary Policy and Interest Rate Caps: A Regime-Shift Approach (June 27, 2012). Available at SSRN: https://ssrn.com/abstract=2094518 or http://dx.doi.org/10.2139/ssrn.2094518

Genevieve Gauthier (Contact Author)

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

Simon Lalancette

HEC Montreal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

René Ferland

University of Quebec at Montreal ( email )

P.O. Box 8888, Downtown Station
Succursale Centre Ville
Montreal, Quebec H3C 3P8
Canada

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