1.To estimate yield volatility, an analyst may use historical yields or an implied yield volatility calculated from current market conditions. Identify the pair of terms below that correctly matches a key ingredient in each estimation process with the process itself.

A)   Historical yield volatility: Derivative prices. Implied yield volatility: The standard deviation formula.

B)   Historical yield volatility: The standard deviation formula. Implied yield volatility: Derivative prices.

C)   Historical yield volatility: Beta. Implied yield volatility: The standard deviation formula.

D)   Historical yield volatility: Duration. Implied yield volatility: A series of log ratios of daily rates.

The correct answer was B)

The historical yield volatility method uses the standard deviation formula. The implied yield volatility method uses derivative prices. In the latter method, the current derivative prices are entered into a formula along with other observed variables. The series of log ratios of daily rates is associated with the historical yield volatility. Beta and duration are not directly relevant.

2.Which of the following is the most questionable assumption associated with the implied yield volatility metric? Implied yield volatility assumes:

A)   that the yield curve is flat.

B)   that the option pricing model used is correct.

C)   a particular shape of the yield curve.

D)   that the bond pricing model used is correct.

The correct answer was B)

If the observed price of an option is assumed to be the fair price and the option pricing model is assumed to be the model that would generate the fair price, then the implied volatility is the yield volatility that, as an input to the option pricing model, would produce the observed option price.

3.Which of the following is a difference between historical yield volatility and implied yield volatility? Implied yield volatility is:

A)   based on an option pricing model.

B)   a more objective measure of the yield volatility.

C)   the true yield volatility.

D)   based on a bond pricing model.

The correct answer was A)

If the observed price of an option is assumed to be the fair price and the option pricing model is assumed to be the model that would generate the fair price, then the implied volatility is the yield volatility that, as an input to the option pricing model would produce the observed option price.