A reexamination of option values implicit in callable Treasury bonds

The mispricing of callable U.S. treasury bonds: A closer look

“…One implication of these findings is that in circumstances where the true option value is small but positive, apparent negative option values will likely be found. Although explanations for the tendency of STRIPS portfolios to undervalue coupon-bearing issues are not formally examined in this article, these results are fully consistent with the tax disadvantage argument in Jordan et al (1995). The fact that the underpricing is more pronounced for discount bonds is especially suggestive in this regard, because the STRIPS tax disadvantage is more substantial relative to discount bonds.…”

“…Based on an examination of almost 300,000 implied option values over the period 1990-1994, negative option values large enough to overcome the bid-ask spread are observed 8.9% of the time. This is somewhat larger than the percentage reported in Jordan et al (1995), but it is substantially smaller than that reported in other studies. Further, contrary to Carayannopoulos, the results show that negative implied put values occur much less frequently than negative implied call values and that Carayannopoulos's conclusion to the contrary is based on an erroneous classification of puts and calls.…”

“…Surprisingly, both studies find that negative option values are very common, implying that callable Treasury bonds are significantly overpriced. In contrast, in an expanded analysis, Jordan, Jordan, and Jorgensen (1995) find that negative option values very rarely occur. Most recently, Carayannopoulos (1995) reexamines the issue with a broader sample of callable bonds and, as in Longstaff and in Edleson et al, reports that negative option values are quite frequent, thereby reopening the debate.…”

“…The striplets method allows a somewhat larger number of callable bonds to be examined. However, as discussed in Jordan et al (1995), STRIPS are taxed disadvantageously, particularly relative to discount coupon The optimal call policy is to call a bond if the price on a call date would otherwise exceed par value. Longstaff (1992) reviews Treasury calls and concludes that the Treasury has historically followed a near-optimal policy.…”

The mispricing of callable U.S. treasury bonds: A note

“…In contrast, Jordan, Jordan, and Jorgensen (1995) and Jordan, Jordan, and Kuipers (1998) find little or no evidence of profitable arbitrage opportunities involving misvalued implicit options. They suggest that what seems to be a puzzle is only the result of tax effects associated with the cash flow replication techniques used in previous studies.…”