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A MULTIFACTOR MODEL OF THE QUALITY OPTION IN TREASURY FUTURES CONTRACTS
Author(s) -
Ritchken Peter,
Sankarasubramanian L.
Publication year - 1995
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.1995.tb00566.x
Subject(s) - futures contract , treasury , bond , economics , econometrics , quality (philosophy) , financial economics , bond valuation , value (mathematics) , mathematics , finance , statistics , philosophy , archaeology , epistemology , history
The values of quality options in Treasury futures contracts are set relative to the prices of all coupon bonds in their respective deliverable sets. As a result, any model used to value the quality option should set its price relative to the set of observed bond prices. This requirement rules out the use of most simple equilibrium models that represent all bond prices in terms of a finite number of state variables. We use the two‐factor Heath‐Jarrow‐Morton model, which permits claims to be priced relative to observable bond prices, to investigate the potential value of the quality option in Treasury bond and note futures. We show that the quality option has significantly more value in a two‐factor interest rate economy than in a single‐factor economy, and that ignoring it could lead to significant mispricing.