Interest Rate Future Quality Options and Negative Interest Rates

Abstract

This article verifies the existence of diversification gains from considering the “quality option asset strategy,” which adds the portfolio replicating the interest rate future quality option, as proposed by Balbás and Reichardt (2010), and a portfolio composed of stock and bonds. The empirical results show that the gains are statistically and economically significant, especially in the negative one-month Euribor rate period. The out-of-sample optimal tangency portfolio, which includes “quality option replicas,” delivers an increase in the Sharpe ratio of around 40%, as well as a positive return-loss offsetting the costs of higher turnover. The main source of the diversification gains emanates from the very low correlation between quality options and stocks.