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

Posted: 6 Sep 2012

See all articles by Jean-Paul Renne

Jean-Paul Renne

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne)

Multiple version iconThere are 3 versions of this paper

Date Written: September 1, 2012

Abstract

This paper presents a no-arbitrage model of the yield curve that explicitly incorporates the central-bank policy rate. 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. The 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 given 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.

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

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

Suggested Citation

Renne, Jean-Paul, A Model of the Euro-Area Yield Curve with Discrete Policy Rates (September 1, 2012). Banque de France Working Paper No. 395, Available at SSRN: https://ssrn.com/abstract=2142330 or http://dx.doi.org/10.2139/ssrn.2142330

Jean-Paul Renne (Contact Author)

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne) ( email )

UNIL, Batiment Internef
Lausanne, 1015
Switzerland

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