Target Rate and Term Structure of Interest Rates

This paper presents a tractable bond valuation model, which further develops the approach proposed by Piazzesi (2005). The short-term inter-bank interest rate is equal to the target rate set by the central bank plus a spread. Bond yields are driven by the expected changes to the target interest rate. Unlike in Piazzesi (2005), accurate approximations provide closed-form solutions for discount bond prices that require no numerical integration. Unlike in Piazzesi, the target interest rate can be constrained to be non-negative and also the nominal short interest rate can virtually always be non-negative. Yields, especially long-term ones, decrease when the central bank is expected to decide more frequent and/or larger changes in the target interest rate. Closed form approximations to likelihood functions simplify model estimation