Target rate factors in short rate models

Abstract

This study investigates the risk associated with the uncertainties in the central bank monetary policy targets in the context of short interest rate models. A class of models is proposed which admits two channels of interest rate risk. In a prototypical case, the short duration channel handles the uncertainties in the target rates decided in the forthcoming Federal Open Market Committee meetings. The target rate factors can be calibrated on the market values of the Fed funds futures. The long duration channel has traditional risk factors. The episodes following the Covid-19 outbreak and the 2022 rate hikes are used as examples in an empirical study.