Estimating bond price volatility from yield volatility

Disclaimer: This talk outlines author's personal view

Derivative pricing is especially challenging in novel and illiquid markets where pricing relies greatly on assumptions and models rather than on known flow of market prices. In the novel market of shekel bond options the estimate of implied volatility could be based on the information about other – more liquid – financial instruments in the market. Here we show relevance but not equivalence of the information from the market of shekel swap rates (volatility of swap rates) to the market of bond
prices (volatility of bond prices). An approximation of bond price implied volatility based on known yield implied volatility may be potentially useful in pricing shekel bond options. We applied numerical simulations and analyzed historical data to examine the validity of such approximation.