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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page Short Rate Expectations, Term Premiums, and Central Bank Use of Derivatives to Reduce Policy Uncertainty
P.A. Tinsley

Abstract: The term structure of interest rates is the primary transmission channel of monetary policy. Under the expectations hypothesis, anticipated settings of the short-term interest rate controlled by the central bank are the main determinants of nominal bond rates. Historical experience suggests that bond rates may remain relatively high even if the short-term interest rate is reduced to zero, in part due to term premiums reflecting uncertainty about future policy. Term spreads due to policy uncertainty may be reduced by central bank trading desk options that provide insurance against future deviations from an announced interest rate policy.

Keywords: Bond options, nominal rate zero bound, term premiums

Full paper (204 KB PDF) | Full paper (472 KB Postscript)

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Last update: March 19, 1999