How to construct a volatility term-structure of interest rates in the absence of market prices
Document ID: 2008-1164 (previously 2008/11)
Published on: 13th November 2008
Author: Zhuoshi Liu
At Barrie & Hibbert we make assumptions about volatility of changes in log nominal forward rates with maturities up to 120 years. However, in financial markets we can observe the time series of forward rates for maturities up to 30 years at best. But with a 30 year maturity we are lucky. And even when we do have data on longer term nominal forward rates, the information we can obtain from the market prices may be spuriously volatile due to the methods used by practitioners (and central banks) to construct the forward curve. Another potential problem is mis-pricing of longer dated bonds. Constructing a volatility term structure is therefore not straight forward.
This note explains how we approach this challenging job at Barrie & Hibbert.
