CHAPTER 26
Eurodollar Volatility: An Update

One of the striking lessons we learned about Eurodollar rate volatility when Eurodollar rates dropped below 2 percent in 2002 was that basis point volatility did not seem to be related to the level of interest rates. This insight prompted us to augment our volatility cone report to include basis point volatility cones in addition to the usual relative rate volatility cones.

The sample volatility cone report shown in Exhibit 26.1, using closing data from September 10, 2002, shows how important the distinction can be. Notice, for example, that on a relative volatility basis (the top left panel), options on the Dec ′02 and Mar ′03 contracts went through a period of appearing to be extremely expensive. At one point, implied relative rate volatility for the Dec ′02 option reached 60 percent, while implied relative rate volatility for the Mar ′03 option traded at 70 percent. Both of these implied volatilities were higher than any historical relative rate volatility for comparable times to these options’ expirations over the previous 2 years. In basis point terms (see top right panel), however, both of these options appeared to be relatively inexpensive, trading in the lower end of the volatility cone. In fact, implied basis point volatility rose very slightly in the face of economic events of the time, but because interest rates had fallen so much, implied relative rate volatility rose dramatically.

EXHIBIT 26.1
Volatility Cones and Return Distributions 2-Year History as of September 10, 2002

In light of our findings about the comparative stability of basis point volatility, the basis point volatility cone would seem to be the more reliable measure of richness or cheapness.