Forward‐Looking Monetary Policy Rules and Option‐Implied Interest Rate Expectations

Abstract

This paper examines the association between option-implied interest rate distributions and macroeconomic expectations in the context of a forward-looking monetary policy rule. We presume that market participants view the policy rule as a guide to the path of future policy rates and price interest rate options in accordance with the policy rule fundamentals. Using data from the UK, we confirm that Libor expectations implied by option prices are consistent with the policy rule variables. The results demonstrate that changes in the distributional form of Libor expectations are strongly associated with changes in the expected inflation and output gaps and financial uncertainty.The original model of Taylor (1993), which was later dubbed "the Taylor rule", is a linear model in which a central bank's target short-term nominal interest rate is defined by the equilibrium real interest rate, current inflation, and the deviations of current inflation and output from their target levels.

Currency Options, Implied Interest Rates and Inflation Targeting

“…Han, Liang, and Wu (2016) use currency options for three major advanced economy currencies (Euro, British Pound, and Swiss Franc) to determine the relationship between options prices and real economic variables across the countries, showing that the contemporaneous default spreads, domestic and cross country spot market trends as well as historical volatility in the spot and stock markets all impact the implied volatility smile. Sihvonen and Vahamma (2014) use UK interest rate options to demonstrate how market participants accurately price in Libor expectations that align with policy rule variables, and that changes in the expectations reflected in the price are associated with changes in expected inflation and output gap. Carlson et al (2005) use the federal funds futures options to extract the implied probably distribution for the Federal Reserve's target policy rate, thereby testing the effects of announcements on market expectations.…”

A Bayesian Time Varying Approach to Risk Neutral Density Estimation

“…The extraction of implied statistical quantities, such as the implied volatility of the asset probability distribution, goes back to the seminal paper by Black and Scholes (). Interest has more recently expanded to other implied moments, such as those of the underlying asset distributions that are constructed from option prices, not only because of their relevance to provide a clearer picture of current market expectations (Vergote and Puigvert, ; Vesela and Puigvert, ; Sihvonen and Vähämaa, ), but also because of their predictive and forward looking power in decision and policy making (Mixon, ; DeMiguel et al ., ; Driessen et al ., ; Atilgana et al ., ). The implied volatility (Atilgana et al ., ), correlation (Skintzi and Apostolos, ; Driessen et al ., ), skewness (Mixon, ; DeMiguel et al ., ) and kurtosis (DeMiguel et al ., ) all help to improve significantly the understanding of expectations, risk management and asset return predictability.…”

The Sensitivity of Interest Rate Options to Monetary Policy Decisions: A Regime‐Shift Pricing Approach

“…Finally, a third group involves interest options. Beber and Brandt (2006) and, more recently, Sihvonen and Vahamaa (2014) explore the linkage between monetary decisions and interest rate options by means of implied probability distributions. Bringing these implied distributions to the intraday frequency, Vergote and Puigvert Gutierrez (2012) examine the impact of ECB communications on Euribor options.…”