Quality options and hedging in Japanese Government Bond Futures markets

Quality options for Japanese Government Bond Futures contracts are analysed using a discrete trinomial tree approach based upon a two-factor Heath, Jarrow, and Morton (1990b) model. The impacts of the quality option on hedging effectiveness are investigated. In general, the pure quality option is found to be relatively small and, while the quality option does not have a dramatic impact upon hedging, accounting for the quality option can improve the performance of optimal hedging strategies.