EMPIRICAL-INVESTIGATION OF THE CANADIAN GOVERNMENT BOND OPTIONS MARKET

This paper constitutes the first empirical investigation of the Canadi an government bond options traded at the Montreal Exchange. Thanks to the availability of transactions data, this market offers an opportuni ty unique in North America for empirical testing of bond option pricin g models. We investigated the validity of a variant of the Schaefer an d Schwartz (1987) time-dependent variance model between May 1986 and D ecember 1988, proposing and testing a closed-form approximation of the model, which performed very well We revealed the existence of pricing biases which are function of the options' maturitY, exercise price, a nd underlying bond duration. The maturity bias only affected options w ith fifteen days Or less to maturity and was consistent with the prese nce of jumps in the yield process. Such jumps are not allowed in the c ontext of our model. We also reported a volatility smile along the exe rcise price dimension, which has been widely documented in the equity options literature. Options on bonds of short duration were shown to b e overpriced, relative to options on long duration bonds. This may be seen as evidence that bond yields are mean reverting. We demonstrated that the sources of bias documented in this study tended to manifest t hemselves when the options were highly illiquid, and that they affecte d only a small fraction of our sample. Abstracting from transactions c osts, simulated hedging strategies designed to take advantage of devia tions from model prices were on average profitable.