Pricing Interest Rate Derivatives Under Monetary Policy Changes

Abstract

Traders worldwide use interest rate options and futures to speculate on future monetary decisions, in particular in countries where the monetary regime is Inflation Targeting (IT). Central Banks under an IT regime tend to define the target rate on scheduled meetings. We propose in this paper a simple and consistent way to explicitly incorporate the potential changes in the target rate during Central Bank's meetings into interest rate futures and option pricing. We calibrate the model to data from Brazil. Brazil came up with the right place to applying our model because it has adopted an inflation targeting regime to monetary policy since 1999 with scheduled meeting to define the target rate and there is a very liquid overnight interest rate derivative market which is used by market participants to bet on future monetary decisions.