Pricing the Quality Option In Treasury Bond Futures1

Peter Ritchken and L. Sankarasubramanian

Mathematical Finance, 1992, vol. 2, issue 3, 197-214

Abstract: This article develops a model for pricing the quality option embedded in the Treasury bond futures contract. Since the option value is set relative to a large family of deliverable bond prices, it is important for the theoretical bond prices to match up to the observed prices. Hence an arbitrage‐based model is used where the forward rate process is initialized at its current observable value. A model for valuing the quality option in an otherwise identical forward contract is also established. This permits the quality option and marking to market costs to be separately quantified. Support is provided for the common practice of pricing Treasury bond futures contracts as forward contracts with an embedded forward quality option.

Date: 1992
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