Interest Rate Volatility and its Effect on Interest Rate Options

Abstract: This paper replicates the study conducted by Guillaume et. al (2013) and derives a relationship between the interest rate volatility and the interest rate level for the Swedish currency (SEK). The results suggest interest rates to be divided into three different regimes consisting of low, intermediate and high rates. The analysis shows that there is a significant proportional trend when looking at the dependence of volatility on rate level for low and high rates, while the variables appear independent for intermediate rate levels. Consequently, there is reason to apply a lognormal model for low and high interest rate regimes and a normal model in intermediate interest rate level environments. Further, the authors extend their study by investigating the effect of the insights on interest rate options. The result indicates that for intermediate level of rates it is not very important to account for a potential dependence on rate level. Moreover, for low and high rates the study finds that there is an exponential relationship between the European call option price and the interest rate level. This leads to the conclusion that the nature of dependence between interest rate volatility and the rate level is important for determining interest rate option prices.