Volatility Estimates are required when interest rate floors or caps are used in pricing floating rate or adjustable rate loans, and allow you to capture the impact of caps and floors on your opportunities. Clients should feel free to develop their own Volatility Estimates using appropriate methods; however, we also provide a recommended set of Volatility Estimates, which will be updated monthly. If you'd like to be notified via email when our Volatility Estimates are updated, go to the Volatility Estimates section and click "Follow" on the right side of the page.
In this article:
- Method to Determine the Recommended Volatility Estimates
- How does using Volatility Estimates affect an opportunity's return?
- What do I need to do?
- Adding Volatility Estimates in PrecisionLender
Method to Determine the Recommended Volatility Estimates
We use standard price quotes from market participants for various interest rate floors across several maturities. More specifically, we evaluate the cost of 3-month LIBOR floors. The floor costs are gathered for each annual term (maturity). We use the explicit floor costs to derive an estimated relative volatility level for use within PrecisionLender. These estimates are derived for both Option Adjusted and Black 76 valuation methods. See Setting Up Caps and Floors for description.
How does using Volatility Estimates affect an opportunity's return?
Within PrecisionLender, the impact of interest rate caps and floors is calculated as a component of interest income.
When an interest rate floor is added to a loan structure, the interest income is expected to increase because the bank owns an option on the interest rate for the loan. Therefore, the addition of an interest rate floor increases an opportunity’s return.
The addition of an interest rate cap to a loan structure shows a decrease to interest income because the bank has offered an option to the borrower. Therefore, the addition of an interest rate cap decreases an opportunity’s return.
Volatility estimates enhance the interest rate sensitivity of option pricing and therefore the calculation of the opportunity’s ROE. These estimates are based on current market interest rate quotes/curves and are subject to market changes. Therefore, volatility estimates may change but the probability of accuracy is certainly enhanced at the time of pricing. Option pricing volatility is assumed to be constant in the absence of volatility estimates.
What do I need to do?
If you do not wish to make changes to your Volatility Estimates, no action is required on your part. You can also set your own Volatility Estimates at the regional level, or you can use PrecisionLender's Recommended Volatility Estimates. If you would like to use the PrecisionLender Recommended Volatility Estimates, you can go to the Volatility Estimates section page and click "Follow" on the right side. This will allow you to receive email updates when we publish a new set of Volatility Estimates. From there, follow the steps below to enter the Volatility Estimates for your region.
Adding Volatility Estimates in PrecisionLender
On the Regions and Users pane of the Administration Section, click on the name of the Region to which you wish to add Volatility Estimates.
Click "Edit" in the upper left corner to make changes to your region's settings.
Scroll down to the Cap & Floor Options section, where you can add, remove, and edit your Volatility Estimates. If you want to specify different estimate for different maturities, click "Add Adjustment", and you can specify different periods of time. If you want to delete an estimate, click the trash can icon to the left of the Volatility Estimate.