Predictive power of the implied volatility term structure in the fixed‐income market

Ren‐Raw Chen, Pei‐Lin Hsieh, Jeffrey Huang and Xiaowei Li

Journal of Futures Markets, 2023, vol. 43, issue 3, 349-383

Abstract: We apply the interest rate model of Chen, Hsieh, and Huang (CHH), the CHH model, to explore the implied volatility (IV) term structure's predictive power for bond excess returns. The CHH model has two advantages over existing models: (1) it delivers the IV of the interest rate, rather than the volatility of the swap rate on which the conventional swaption pricing model is built, and (2) the CHH model systematically summarizes 100 swaption prices into a volatility term structure with 10 succinct IVs. By exploiting these advantages, we demonstrate the IV term structure's predictive power and its connection to economic conditions.

Date: 2023
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https://doi.org/10.1002/fut.22386

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