On the Future Contract Quality Option: A New Look Articles uri icon

publication date

  • January 2010

start page

  • 1217

end page

  • 1229

issue

  • 15

volume

  • 20

international standard serial number (ISSN)

  • 0960-3107

electronic international standard serial number (EISSN)

  • 1466-4305

abstract

  • This article provides a new method for replicating and pricing the quality options usually embedded in many future contracts. The replicating strategies may draw on both the future contract as well as
    its related calls and puts. They also yield the quality option
    theoretical price in perfect markets, as well as upper and lower bounds
    for its bid or ask prices if frictions are incorporated. With respect to
    previous literature, this new approach seems to reflect five
    contributions: First, the analysis does not depend on any dynamic
    assumption concerning the Term Structure of Interest Rates (TSIR)
    behaviour; second, it incorporates the information contained in calls
    and puts on the future contract; third, it allows us to use real market
    perfectly synchronized prices; fourth, transaction costs can be
    considered and, finally, this article shows that the quality option may
    be a useful security in the portfolio of many traders. These traders
    will make the future contract more effective as a hedging instrument.
    This article also presents an empirical test involving the German
    market.