The Volatility of Low Rates

Traditional, fixed-income risk models are based on the assumption that bond risk is directly proportional to
the interest rate, i.e. that the interest-rate distribution is "log-normal." Two corollaries would then follow.
Firstly, nominal interest rates could never be negative. Furthermore, bond volatility vanishes when interest
rates approach zero. These conclusions are obviously wrong, if we observe debt situation in a country such
as Germany. Should we then infer that the traditional way to model fixed income is no longer valid? Our
study, based on bond-data back tests, covering 40 years that encompass both periods of low rates and of high
inflation, demonstrates that the traditional approach still applies. When interest rates are low, the bond risk is
proportional to the rate, increased by 1%. As an example, when interest rates shift from 1% to 0%, the bond
risk is divided by 2, instead of becoming null. The second conclusion is that the interest rate volatility behaves
as if the absolute minimum level for a rate was not zero, but -1%.

Length of Resource
11 pages
Raphael Douady
Date Published
Publication Type
Resource Type

ResourceID: 73017

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