Quality Option Profits, Switching Option Profits, and Variation Margin Costs: An Evaluation of Their Size and Impact on Treasury Bond Futures Prices

Theodore M. Barnhill

Journal of Financial and Quantitative Analysis, 1990, vol. 25, issue 1, 65-86

Abstract: This paper provides empirical evidence that the quality option in T-bond futures is much less valuable than previously indicated. In addition, a dynamic trading strategy involving multiple switches of the cash bonds held in a long cash versus short futures position is shown to produce substantially greater profits than the single exercise of the quality option. These findings suggest that the optimal management of long cash/short futures positions is likely to involve dynamic trading strategies while passive strategies appear more appropriate for short cash/long futures positions. It is also shown that required variation margin payments are frequently large and may impact the profitability and risk of such positions to a greater extent than either of these options. Further, evidence is given indicating that observed T-bond futures prices reflect an imputed value for the options and risks inherent in such positions.

Date: 1990
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