A bridge between mortgage TBA options and swaptions
Shijun Liu provides basis-point volatility option pricing formulas for swaptions and mortgage to-be-announced options that make direct comparison of volatilities easy and transparent across the two interest rate derivatives markets. Basis-point volatility models remove much of the skew observed when volatilities have been quoted in Black volatilities, as in the recent market environment
In the interest rate derivatives markets, options are usually quoted in Black volatilities. However, Black volatilities are measured differently for different instruments. For example, they are measured by the lognormal yield1 volatility in swaptions but by the lognormal price volatility in mortgage to-be-announced (TBA) options, which are bond options. Many dealers also quote swaptions in basis-point (BP) volatility, which is derived under the assumption that swap rates are normally distributed
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