Conferences at Department of Economics, University of Toronto, RCEF 2012: Cities, Open Economies, and Public Policy

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Bayesian estimation of probabilities of target rates using Fed Funds futures options

Mark Fisher

Last modified: 2012-06-25


This paper adopts a Bayesian approach to the problem of extracting the probabilities of the FOMC's target Fed Funds rate from option prices, extending the framework provided by Carlson etal (2005) in a number of directions. Likelihood-related novelties include (i) the allowance for "slippage" between the target rate and the month-average rate and (ii) accounting for the nonnegativity of options prices by truncating the measurement error. In addition, we generalize the likelihood for target rates to include the likelihood for target-rate \emph{paths}. Prior-related novelties include (i) enforcing nonnegativity constraints on the probabilities and (ii) the "informed ignorance" prior that allows for the inclusion of a large number of possible target rates (which is especially important for joint/path estimation).

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