Extracting Market Expectations on the Duration of the Zero Interest Rate Policy from Japan's Bond Prices

This paper aims to extract the expectations of market participants on the duration of the Zero Interest Rate Policy (ZIRP) by the Bank of Japan by modeling the term structure of interest rates. Under the ZIRP, particularly the short-term and medium-term interest rates are so low that we face difficulty applying traditional yield curve models such as the Vasicek model to them. This circumstance motivated us to model the expectations of market participants on the duration of the ZIRP by regarding it as one of the risk factors of a yield curve. To be specific, we constructed a yield curve model with the following two interest-rate generating process by maturity zone: (i) the short-term interest rate zone follows the traditional Vasicek model augmented by incorporating the probability of policy duration as one of the risk factors, and (ii) the long-term interest rate zone is determined by risk prices perceived in markets. By taking these steps, we significantly improved the fitting of the yield curve model under the ZIRP.