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Estimating the implied distribution of the future short term interest rate using the Longstaff-Schwartz model

Author

Listed:
  • Hördahl, Peter
Abstract
This paper proposes the use of the two-factor term-structure model of Longstaff and Schwartz (1992a, LS) to estimate the risk-neutral density (RND) of the future short-term interest rate. The resulting RND can be interpreted as the market's estimate of the density of the future short-term interest rate. As such, it provides a useful financial indicator of the perceived uncertainty of future developments in the short-term interest rate. The LS approach used in this paper provides an alternative to option-based estimation procedures, which may be useful in situations here options markets are not sufficiently developed to allow estimation of the implied distribution from observed option prices. A simulation-based comparison of these two approaches reveals that the differences in the results are relatively small in magnitude, at least for short forecast horizons. Furthermore, the LS model is quite successful in capturing the asymmetries of the true distribution. It is therefore concluded that the LS model can be useful for estimating the distribution of future interest rates, when the purpose is to provide a general measure of the market' s perceived uncertainty, for example as an indictor for monetary policy purposes. JEL Classification: C15, E43, E47, G12

Suggested Citation

  • Hördahl, Peter, 2000. "Estimating the implied distribution of the future short term interest rate using the Longstaff-Schwartz model," Working Paper Series 16, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:200016
    Note: 14047
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp016.pdf
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    References listed on IDEAS

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    Cited by:

    1. Leo Krippner, 2003. "Modelling the Yield Curve with Orthonormalised Laguerre Polynomials: A Consistent Cross-Sectional and Inter-Temporal Approach," Working Papers in Economics 03/02, University of Waikato.
    2. Vahamaa, Sami, 2005. "Option-implied asymmetries in bond market expectations around monetary policy actions of the ECB," Journal of Economics and Business, Elsevier, vol. 57(1), pages 23-38.
    3. Don H. Kim, 2008. "Zero bound, option-implied PDFs, and term structure models," Finance and Economics Discussion Series 2008-31, Board of Governors of the Federal Reserve System (U.S.).
    4. Jan Marc Berk, 2002. "Consumers' Inflation Expectations And Monetary Policy In Europe," Contemporary Economic Policy, Western Economic Association International, vol. 20(2), pages 122-132, April.

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    More about this item

    Keywords

    density forecast; forecast evaluation; implied distribution; interest rate expectations; Longstaff-Schwartz model; risk-neutral density;
    All these keywords.

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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