Term structure of volatilities and yield curve estimation methodology

Abstract

In this paper, we estimate the term structure of interest rate volatilities. It is well known that volatility is the main input for option and other fixed income derivatives valuation models. However, we find that volatility estimates depend significantly on the model used to estimate the zero coupon yield curve (Nelson and Siegel; Vasicek and Fong) and the assumption concerning the heteroskedasticity structure of errors (OLS or GLS weighted by duration). We conclude in our empirical analysis that there are significant differences between these volatility estimates in the short term (less than one year) and in the long term (more than 10 years).

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