Real-World Interest Rate Calibration: How to set a target path for interest rates
Document ID: 2009-1521 (previously 2009/10)
Published on: 27th August 2009
Author: Zhuoshi Liu & Steffen Sorensen
In a real-world interest calibration, we have a choice between setting a target for the short term interest rate at one specific future point in time, and setting a target for the entire path of short term interest rates. This note explains our methodology for setting a target path for the nominal short rate consistent with the following observations: 1) We do not make frequent changes to our long term expectations. 2) Interest rates are mean reverting. 3) Short term nominal forward rates have good informational content about future expectations while long term forward rates do not. 4) The mean reversion level of interest rates needs an appropriate economic justification.
