Discrete Choice Term Structure Models : Theory and Applications

With Bruno Feunou. Central banks around the world restrict changes in their policy rate to a small set of possibilities. Typically, these are a few multiples of 0.25% away from the current policy rate.  In economics, this is an example of the well-known class of ordered choice problems. This paper bridges the gap between discrete-choice problems and asset pricing. We generalize the standard probit-logit case and provide the implications from the absence of arbitrage to develop a wide class of term structure models.  Empirically, we find significant non-linearitites in the Fed’s policy function and in US interest rates. The paper is here, Discrete Choice Term Structure Models, and the abstract follows.

Abstract

The relationship between inflation, unemployment and the Federal Reserve Target rate is not linear. This is clear when the Target rate reaches its lower bound but it is also the case more generally. We introduce the class of Discrete Choice Dynamic Term Structure [DCDTS] models where the latent policy indicator threshold points are stochastic. The resulting Target rate is discrete, non-linear and can be restricted to non-negative values. Empirically, we focus on the response of the Central Bank, the responses of bond yields and that of interest rate derivatives to inflation and employment growth news. We find significant non-linearities where, in contrast with latent factors or regime-switching models, sensitivity coefficients can be interpreted directly as functions of inflation and employment. The evidence is consistent with the Fed varying the weights given to each component of its dual mandate with varying economic conditions.