
How to construct a bond volatility index and extract market information
Volatility indices, based upon the methodology of the Cboe volatility index (VIX), serve as measures of near-term market uncertainty across asset classes. They are constructed from out-of-the-money put and call premia using variance swap pricing. Volatility indices for fixed income markets are of particular importance, as they allow inferring market expectations about discount factors and credit premia, which have repercussions on all assets and the broader economy. There is a step-by-step construction plan for building a bespoke index for any rates market with liquid futures and options. Such a volatility index supports asset management in two ways. First, it is a valid basis for portfolio risk management and volatility targeting. Second, it can be used for extracting forward-looking market information, including changing probability quantiles for prices and rates, probabilities of certain extreme events, and the skewness of expectations.