Article: article from journal or magazin.
A tractable interest rate model with explicit monetary policy rates
European Journal of Operational Research
This paper proposes a novel interest rate model that presents simple analytical pricing formulas for interest rate-based derivatives, including swaps, futures, swaptions, caps and floors. Exploring the regime-switching feature of Markov chains, the proposed model focuses on discrete changes in the central bank policy rates the main driver of short-term rate fluctuations. An empirical analysis shows that the proposed model generally outperforms other standard short-term rate models in fitting cross-sections of options prices. Moreover, the explicit nature of policy rates, to some extent, enables the model to infer risk-neutral probabilities of the central-bank rate decisions.
Yield curve, Option pricing, Regime switching, Market expectations
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