Forward-Looking Monetary Policy Rules and Option-Implied Interest Rate Expectations


  • The authors would like to thank an anonymous referee, Vladimir Gatchev, Markku Lanne, Karl Larsson, Ji-Chai Lin, Leonardo Morales-Arias, Seppo Pynnönen, Larry D. Wall, Henning Weber, Paolo Zagaglia, and seminar participants at the Bank of Finland, the Kiel Institute for the World Economy, Louisiana State University, the University of Central Florida, Stockholm University, the 2010 Graduate School of Finance Research Workshop, the 2010 Nordic Finance Network Workshop, and the 2011 Eastern Finance Association Meeting for helpful discussions and comments. This paper received the Outstanding Paper in Financial Institutions Award at the 2011 Eastern Finance Association Meeting.


This paper examines the association between option-implied interest rate distributions and macroeconomic expectations in the context of a forward-looking monetary policy rule. We presume that market participants view the policy rule as a guide to the path of future policy rates and price interest rate options in accordance with the policy rule fundamentals. Using data from the UK, we confirm that Libor expectations implied by option prices are consistent with the policy rule variables. The results demonstrate that changes in the distributional form of Libor expectations are strongly associated with changes in the expected inflation and output gaps and financial uncertainty. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:346–373, 2014