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Review of Finance Advance Access published online on March 26, 2009
Review of Finance, doi:10.1093/rof/rfp001
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The Authors 2009. Published by Oxford University Press on behalf of the European Finance Association. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Market Anticipation of Fed Policy Changes and the Term Structure of Interest Rates*

Massoud Heidari1 and Liuren Wu2

1 Caspian Capital Management
2 Zicklin School of Business, Baruch College, City University of New York

The Federal Reserve adjusts the federal funds target rate discretely, causing discontinuity in short-term interest rates. Unlike Poisson jumps, these adjustments are well anticipated by the market. We propose a term structure model that incorporates an anticipated jump component with known arrival times but random jump size. We find that doing so improves the model performance in capturing the term structure behavior. The mean jump sizes extracted from the term structure match the realized target rate changes well. Specification analysis indicates that the jump sizes show strong serial dependence and dependence on the interest-rate factors.

Key Words: E43 • G12 • G13 • C51

* We thank Franklin Allen (the editor), an anonymous referee, David Backus, Peter Carr, Silverio Foresi, Michael Johhanes, Gregory Klein, Karl Kolderup, Markus Leippold, James Lothian, and seminar participants at Baruch College for helpful suggestions and discussions.


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