Forecasting swap rate volatility with information from swaptions

Summary

Focus 

We calculate the swap rate model-free implied volatility from over-the-counter swaption quotes for swap rates with a wide cross section of tenors and with a variety of times to expiration. We examine the predictive power of the swap rate model-free implied volatility on future realised volatility of swap rates and compare the in-sample and out-of-sample predictability of the model-free implied volatility with other commonly used predictors.

Contribution 

The information content of derivative prices for the interest rate swap is less studied although the market is large. This paper contributes to the literature on the information content of the interest rate derivatives market based on reliable quote data from principal inter-dealer brokers. In particular, we complete the literature by focusing on the superior information content of the option-implied volatility. Also, as both the financial industry and academia continue to focus attention on the fear index in the equity market, our study helps to draw attention to the fear index in the interest rate swap market.

Findings 

We find that the swap rate model-free implied volatility shows strong and significant predictability for future realised volatility. The predictive power of the swap rate model-free implied volatility is stronger than either the lagged realised volatility or the conditional volatility estimated from a GARCH model. Adding other predictors neither weakens the effects of the swap rate model-free implied volatility but nor does it further improve the forecasting performance. The superior predictive performance is further confirmed by investigating the out-of-sample performance and it persists through different market conditions and with longer forecasting horizons.

Abstract

We examine the predictability of the model-free implied volatility from swaptions on future realized volatility of the underlying swap rates. The model-free implied volatility demonstrates significant predictability on future realized volatility of swap rates along a wide cross-section of tenors. The predictive power of the model-free implied volatility is superior to the predictability of lagged realized volatility and GARCH-type conditional volatility. The superior predictive power of the model-free implied volatility also holds out of sample, in different market states and with longer forecasting horizons.

JEL classification: C23, G11, G12

Keywords: swaption, model-free implied volatility, predictive regression, interest swap rate