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What Are the Odds? Option-Based Forecasts of FOMC Target Changes

By William R. Emmons, Aeimit K. Lakdawala and Christopher J. Neely

Abstract

This article uses probability forecasts derived from options to assess evolving market uncertainty about Federal Reserve monetary policy actions in a variety of recent events and episodes. Options on federal funds futures contracts reveal a complete probability density function over possible Federal Reserve target rates, thus augmenting the expectations provided by federal funds futures contracts. Option-based forecasts are most useful when more than two federal funds target outcomes are plausible at an upcoming policy meeting. (JEL E47, E52, G13) Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 543-61. Options on federal funds futures contracts provide information about market expectations of Federal Open Market Committee (FOMC) monetary policy actions above and beyond that provided by federal funds futures contracts alone. In particular, options provide important information about the dispersion and skewness of market expectations. Under some assumptions, option prices imply a complete probability density function (PDF) over possible FOMC target-rate choices. This article uses the method of Carlson, Craig, and Melick (2005) to extract an implied riskneutral probability density function over possible future federal funds target rates from daily option prices. Option-based forecasts are most useful when more than two federal funds target outcomes are plausible at an upcoming FOMC meeting. If only one or two meeting outcomes are plausible, a futures-based forecast is simpler and more appropriate

Year: 2011
OAI identifier: oai:CiteSeerX.psu:10.1.1.188.8200
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