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On the future contract quality option: a new look

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  • Alejandro Balbas
  • Susana Reichardt

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.

Suggested Citation

  • Alejandro Balbas & Susana Reichardt, 2010. "On the future contract quality option: a new look," Applied Financial Economics, Taylor & Francis Journals, vol. 20(15), pages 1217-1229.
    • Handle: RePEc:taf:apfiec:v:20:y:2010:i:15:p:1217-1229
    DOI: 10.1080/09603107.2010.482515
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