Pricing and hedging the Korean treasury bond futures

Abstract

Traditionally, people values KTB futures contracts using the model based on the cost-of-carry argument. However, the underlying commodity for the KTB futures is non-tradable, and so the cost of carry argument cannot be applied to the KTB futures. This paper regards KTB futures contracts as interest-rate derivatives, and prices them using the Hull-White term structure model and the Black-Karasinski term structure model. This paper documents that (1) the market prices of KTB futures are more close to Hull- White model and B-K model price than the price by the cost-of-carry argument, though the KTB futures are generally underpriced in the market even under these model; (2) The extent of underpricing is a decreasing function of the remaining maturity of the futures, and becomes smaller recently; (3) The cost of carry argument relatively overprices the KTB futures, and the degree of overpricing is a decreasing function of interest rates and the remaining maturity of the futures; (4) The daily resettlement in the futures contracts affects the futures price very little; (5) The comparison of hedging performance of each model and investment strategies based on the theoretical pricing models are represented.