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Interest Rates as Options
The Journal of Finance
Vol. 50, No. 5 (Dec., 1995), pp. 1371-1376
Stable URL: http://www.jstor.org/stable/2329320
Page Count: 6
You can always find the topics here!Topics: Investment risk, Interest rates, Financial investments, Capital costs, Inflation rates, Financial instruments, Yield curves, Economic inflation, Underground economies, Economic capital
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Since people can hold currency at a zero nominal interest rate, the nominal short rate cannot be negative. The real interest rate can be and has been negative, since low risk real investment opportunities like filling in the Mississippi delta do not guarantee positive returns. The inflation rate can be and has been negative, most recently (in the United States) during the Great Depression. The nominal short rate is the "shadow real interest rate" (as defined by the investment opportunity set) plus the inflation rate, or zero, whichever is greater. Thus the nominal short rate is an option. Longer term interest rates are always positive, since the future short rate may be positive even when the current short rate is zero. We can easily build this option element into our interest rate trees for backward induction or Monte Carlo simulation: just create a distribution that allows negative nominal rates, and then replace each negative rate with zero.
The Journal of Finance © 1995 American Finance Association