BY ANTONIO MELE AND YOSHIKI OBAYASHI
One of the pillars supporting the recent movement toward standardized measurement and trading of
interest rate volatility is a novel theory of options-based model-free fixed income volatility pricing. The meanin gof this mouthful is best understood by working backwards: "fixed income volatility pricing" refers to the valuation of a contract with payooffs tied to a specific measure of realized variance of an underlying fixed income instruemnt (genericaly, a "variance swap"); "model-free" signifies the absence of reliance on modeling assumptions beyond specification of standard price dynamics and absence of arbitrage; and "options-based" relates to the valuation technique of spanning variance swap payoffs with those of options on the same underlying.