Historical Rate Volatility as a Fallback in Bond OAS Models

Summary

The note offers a possible historical explanation for a fixed fallback volatility used in a bond option-adjusted spread model. It says term-structure models from that period often relied on constant volatility assumptions, commonly calibrated to realized historical volatility rather than option-implied volatility. A cited historical study reported realized volatility for the three-month Treasury rate over a long sample, with a value close to the fallback used by the questioner’s model.

The match suggests a plausible source for the legacy assumption, particularly since the model was intended to align with an established market model. It does not establish the original developers’ reasoning or confirm that the same parameter remains appropriate today. The response provides no calibration details, alternative estimates, or analysis of how the choice affects OAS outputs. Treat the proposed origin as an informed conjecture grounded in historical evidence, rather than a verified account of the model’s implementation.

Key ideas

• Older term-structure models often used fixed volatility inputs.
• Historical realized volatility was one basis for those assumptions.
• A reported Treasury-rate volatility near the fallback value may explain its origin.
• The historical match is suggestive, not proof of the model developers’ rationale or current suitability.

Tags

# Fallback Interest rate volatility for OAS model


# Fallback Interest rate volatility for OAS model












The Bond OAS computation model used in our bank (The model was created in the 90s and the people who worked on it then are no longer part of the company) uses a fallback interest rate volatility of 27.5%. I am unable to understand the rationale behind this assumption. All I know is the model was created to align with Bloomberg’s OAS model. Why is the fallback volatility of 27.5% used?

## Answer by Helin (score 2, accepted)

https://quant.stackexchange.com/a/40826

Term structure models created in that era frequently used fixed volatility assumptions. These assumptions were usually based on historical realized vols (instead of implied vols from options). A paper published by Salomon Brothers in 1997 reported that the realized volatility for 3-month Treasury rate from 1977 to 1997 to be 27.3%, which might be what the modeler at your bank saw and chose.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.