Value Commentary

Stay Normal: A Testimony of the Market and the ADCO Volatility Index
By Alex Levin

In September of 2002, we published a research paper on the "conscientious choice" of an interest rate model, having mortgage investors in mind. We argued that the only remaining fossil from the old days of interest rate lognormality is the proportional volatility quotation standard, otherwise known as Black volatility. We observed unambiguous signs of normalization and argued for a normal (Hull-White) model. Two major reasons for this recommendation were (1) the actual daily rate deviations and (2) the observed skew of the swaption market.

We also quantified the role of negative rates by pricing a hypothetical derivative, a zero-struck floor. Our analysis found negative rates were rather harmless to the mortgage valuation problem. These conclusions were made last year in what was then thought to be a relatively high volatility and low rate level environment.

Since completeing that research, the long rates have dropped by another 150-200 bps, planting doubts even in the minds of those who adore normality. "What would you say now," many ask. And our answer, recklessly brave as it may sound, is "Stay Normal", but not without good reason.

Actual rate deviations

Let us compare, in the graph on the next page, the daily deviation chart published a year ago for the 1989-2002 history of the 10-yr swap rate with the one recently updated >>>