Expectations of Monetary Policy in Australia Implied by the Probability Distribution of Interest Rate Derivatives

This paper describes and compares different methods of extracting the implied probability distribution of the underlying interest rate futures from the prices of traded options on these futures as well as from past futures prices. These methods are applied to short-term contracts on bank accepted bills trading on the Sydney Futures Exchange. The information on the distribution of the underlying asset thus obtained is very important to the central bank authorities since this allows them to monitor market expectations regarding future price movements. Alternatively, market reaction to central bank monetary policy changes may be judged this way. It is also important to practitioners for use in pricing over the counter (OTC) or exotic products where the trading volume is not particularly high. In that situation, the information on the distribution recovered from highly traded products from the exchange may be used as representative for the OTC products as well. As an empirical application, the recovered information on distribution is analysed in the context of reductions in interest rates in Australia by the Reserve Bank between July 1996 and May 1997.