The Concept and Measures of Interest Rate Volatility
In this entry, we introduce the concepts of market volatility and discuss how it is measured. The dynamics of rates are subject to market forces, mean reversion, and combinations of diffusions and jumps.
BASIC DEFINITIONS AND FIRST FINDINGS
We can't tell in advance what interest rates will be. Investors may be either enriched or bankrupted from sudden changes in interest rates. Financial institutions devote considerable resources to risk management and hedging. Yet, if future interest rates were deterministic, there would be no need to hedge. Coping with uncertainty is a central feature of investment markets.
The pricing of options and embedded-options instruments utilizes a statistical concept to describe the magnitude of potential interest rates changes. The key notion is the volatility of interest rates. While this term conjures up images of instability, flares of activity, and unpredict-ability, it is ...