The Reaction of Term Structure of Interest Rates to the Monetary Policy Actions

Abstract

This paper analyzes the response of the Term Structure of discount rates to the changes in the Federal Funds Target Rate. It also suggests a method of hedging fixed income portfolio's risk to the unexpected changes in monetary policy. We use two alternative widely used models of term structure of interest rates - the Extended Nelson-Siegel and the Extended Vasicek models. We show that only the slope of the term structure of zero-rates (also known as the spread between medium and short term rates) reacts significantly to the monetary policy. We also demonstrate that in our case, the Extended Vasicek model outperforms the Extended Nelson-Siegel model in capturing the impact of the monetary policy on the shape of the term structure. The results here can be used in practice to hedge the risk of the changes in the shape of the term structure of rates, due to monetary policy actions.

Keywords: Term Structure, Nelson-Siegel Model, Vasicek Model, Monetary Policy, Federal Funds Target Rate.

JEL Classification: E52, G14