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Article

Embedded Options in Treasury Bond Futures Prices: New Evidence

Ren-Raw Chen, Hann-Shing Ju and Shih-Kuo Yeh
The Journal of Fixed Income Summer 2009, 19 (1) 82-95; DOI: https://doi.org/10.3905/JFI.2009.19.1.082
Ren-Raw Chen
is a professor of finance at the Graduate School of Business Administration at Fordham University in New York, NY.
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  • For correspondence: rchen@fordham.edu
Hann-Shing Ju
is an assistant researcher of finance at National Chung Hsing University in Taichung, Taiwan.
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  • For correspondence: d9164202@mail.nchu.edu.tw
Shih-Kuo Yeh
is a professor of finance at National Chung Hsing University in Taichung, Taiwan.
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  • For correspondence: seiko@nchu.edu.tw
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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.

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The Journal of Fixed Income
Vol. 19, Issue 1
Summer 2009
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Embedded Options in Treasury Bond Futures Prices: New Evidence
Ren-Raw Chen, Hann-Shing Ju, Shih-Kuo Yeh
The Journal of Fixed Income Jun 2009, 19 (1) 82-95; DOI: 10.3905/JFI.2009.19.1.082

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Embedded Options in Treasury Bond Futures Prices: New Evidence
Ren-Raw Chen, Hann-Shing Ju, Shih-Kuo Yeh
The Journal of Fixed Income Jun 2009, 19 (1) 82-95; DOI: 10.3905/JFI.2009.19.1.082
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  • Article
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    • THE QUALITY OPTION AND THE FUTURES PRICE
    • EMPIRICAL STUDY
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