How Is Volatility Estimated?

There are two methods commonly used to estimate volatility.

The first method is by estimating historical volatility; volatility is calculated by using data from the recent past with the assumption that what has happened recently is indicative of the future.

A second method to estimate volatility is based on observed market prices of interest rate derivatives (e.g., swaptions, caps, floors). This approach is called implied volatility.

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