Embedded Options in Treasury Bond Futures Prices: New Evidence

Abstract

The Treasury bond futures contract has known embedded options, namely the quality option that permits the short side to deliver the cheapest bond and the three timing options that permit the short side to deliver at the most favorable time. In this article, the authors use a two-factor Cox–Ingersoll–Ross term structure model calibrated to the Treasury yield curve to compute the futures price with the forward pricing methodology. Using weekly futures prices from January 1992 through December 2000, they discover a substantial difference between the risk-neutral expectation used in the literature and the forward expectation that requires a recursive algorithm. The authors find that the correctly estimated futures price with the quality option is 1% lower on average than the futures price estimated in the literature. They also estimate the end-of-month timing option to be 23 basis points on average. This indicates that the end-of-month timing option value has been overestimated in the literature because of a wrongly estimated quality option value.