We found it useful to design a market volatility index - a single number that "represents" the swaption market relevant for our mortgage analytics. It is merely a way to communicate with practitioners and can serve as a convenient risk assessment tool. We use our rigorous volatility calibration technique designating a family of At the Money (ATM) swaptions as its input and computing one short-rate volatility constant - the ADCO volatility index. For deriving this index, the mean reversion is set to zero, and the single short-rate volatility constant was found to best match the long-rate volatility observed in the swaption market - on average. We normally do not use this set-up for actual mortgage OAS valuation, where we strongly prefer doing a much more accurate job optimizing a time-dependent volatility and a mean reversion constant.

The graph below represents three ADCO volatility indices ("sigmas") computed for the last year using the three different models we support, the Hull-White normal model, the Black-Karasinski lognormal model, and the Squared Gaussian model (chi-squared distribution with one degree of freedom).

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