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Pricing the Quality Option In Treasury Bond Futures1

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  • Peter Ritchken
  • L. Sankarasubramanian

Abstract

This article develops a model for pricing the quality option embedded in the Treasury bond futures contract. Since the option value is set relative to a large family of deliverable bond prices, it is important for the theoretical bond prices to match up to the observed prices. Hence an arbitrage‐based model is used where the forward rate process is initialized at its current observable value. A model for valuing the quality option in an otherwise identical forward contract is also established. This permits the quality option and marking to market costs to be separately quantified. Support is provided for the common practice of pricing Treasury bond futures contracts as forward contracts with an embedded forward quality option.

Suggested Citation

  • Peter Ritchken & L. Sankarasubramanian, 1992. "Pricing the Quality Option In Treasury Bond Futures1," Mathematical Finance, Wiley Blackwell, vol. 2(3), pages 197-214, July.
    • Handle: RePEc:bla:mathfi:v:2:y:1992:i:3:p:197-214
    DOI: 10.1111/j.1467-9965.1992.tb00029.x
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    Cited by:

    1. Bing-Huei Lin & Ren-Raw Chen & Jian-Hsin Chou, 1999. "Pricing and quality option in Japanese government bond futures," Applied Financial Economics, Taylor & Francis Journals, vol. 9(1), pages 51-65.
    2. Peter Ritchken & L. Sankarasubramanian, 1995. "A Multifactor Model Of The Quality Option In Treasury Futures Contracts," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 18(3), pages 261-279, September.
    3. Ren-Raw Chen & Shih-Kuo Yeh, 2012. "Analytical bounds for Treasury bond futures prices," Review of Quantitative Finance and Accounting, Springer, vol. 39(2), pages 209-239, August.
    4. Peter H. Ritchken & L. Sankarasubramanian, 1992. "On Markovian representations of the term structure," Working Papers (Old Series) 9214, Federal Reserve Bank of Cleveland.
    5. U. Cherubini & M. Esposito, 1995. "Options in and on interest rate futures contracts: results from martingale pricing theory," Applied Mathematical Finance, Taylor & Francis Journals, vol. 2(1), pages 1-16.
    6. Balbás, Alejandro & Reichardt, Susana, 2006. "On the future contract quality option: a new look," DEE - Working Papers. Business Economics. WB wb063711, Universidad Carlos III de Madrid. Departamento de Economía de la Empresa.
    7. João Pedro Vidal Nunes & Luís Alberto Ferreira De Oliveira, 2007. "Multifactor and analytical valuation of treasury bond futures with an embedded quality option," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 27(3), pages 275-303, March.

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