On the future contract quality option: a new look

Abstract

The paper provides a new method to replicate and price the quality options usually embedded in many future contracts. The replicating strategies may draw on both the future contract and its related calls and puts. They also yield the quality option theoretical price in perfect markets, as well as upper and lower bounds for its bid or ask prices if frictions are incorporated. With respect to previous literature, this new approach seems to reflect four contributions: Firstly, the analysis does not depend on any dynamic assumption concerning the TSIR behaviour, secondly, it incorporates the information contained in calls and puts whose underlying security is the future contract, thirdly, it allows us to use real market perfectly synchronized prices, and fourthly, transaction costs can be considered. The paper presents an empirical test involving the German market that reveals some differences with regard to previous studies. Abstract. The paper provides a new method to replicate and price the quality options usually embedded in many future contracts. The replicating strategies may draw on both the future contract and its related calls and puts. They also yield the quality option theoretical price in perfect markets, as well as upper and lower bounds for its bid or ask prices if frictions are incorporated. With respect to previous literature, this new approach seems to reflect four contributions: Firstly, the analysis does not depend on any dynamic assumption concerning the TSIR behaviour, secondly, it incorporates the information contained in calls and puts whose underlying security is the future contract, thirdly, it allows us to use real market perfectly synchronized prices, and fourthly, transaction costs can be considered. The paper presents an empirical test involving the German market that reveals some differences with regard to previous studies. Keywords

Interest Rate Future Quality Options and Negative Interest Rates

“…This section explores the methodology developed in this paper. Firstly, we present the main results of Balbás and Reichardt (2010) about the valuation of the quality option embedded in the interest rate future contract. They draw on a classical static approach.…”

“…In this paper we analyse the diversification opportunities offered adding by the interest rate future contract quality option to a traditional portfolio comprised of stocks, bonds and the riskfree asset. To do this, we follow the approach of Balbás and Reichardt (2010) in order to price the most expensive quality option usually embedded in the interest rate future contracts. 4 They show that there is a replicating portfolio of the most expensive quality option that involves trading the future contract value itself and one bond among the set of deliverable bonds: the investor can buy (sell) the quality option through short selling (buying) the discount bond with a face value equal to the interest rate future price and buying (short selling) the deliverable bond that maximizes the quality option value.…”

“…4 They show that there is a replicating portfolio of the most expensive quality option that involves trading the future contract value itself and one bond among the set of deliverable bonds: the investor can buy (sell) the quality option through short selling (buying) the discount bond with a face value equal to the interest rate future price and buying (short selling) the deliverable bond that maximizes the quality option value. Interestingly, Balbás and Reichardt (2010) show that investment strategies involving the quality option (termed the "quality option asset" hereinafter) deliver apparent profitability. Such strategies consist of selling the replicating portfolio of the quality option and buying it later on, profiting from the fact that the quality option price seems to follow a decreasing path.…”

“…We have considered the investment strategies involving the Euro-Schatz Future contract, the Euro-4 There are several alternatives for pricing the quality option. As discussed in Balbás and Reichardt (2010) the usual way prices the option at any date before the future maturity as the difference between the theoretical future price of the cheapest to deliver bond and the future price reflected by the market (Hedge, 1990;Hemler, 1990;Stickland, 1992;Yu, 1997).…”

A Literature Review of Treasury Bond Futures Pricing and Arbitrage Method

“…This approach has a certain similarity with selling the largest basis of deliverable bonds, so you can choose to sell the options to select bonds, then buy them in the future, so substantial arbitrage income can obtain [11]. Grieves and Marcus (2010) [12] used bond future and note future of CBOT transaction to empirically test the article of Grieves and Marcus (2005) [13] and found that the results obtained using only two deliverable bonds (highest duration and the lowest duration deliverable bonds) method is consistent with the results obtained in note future market.…”