What it means
In a Treasury futures contract, the seller (the "short") can deliver any of several eligible bonds when the contract matures. The amount the seller is paid, called the invoice price, is worked out from the futures settlement price set at the close of trading on the day the seller gives notice.
The seller then has until later that evening to announce that delivery will take place. Because the cash bond market stays open after the futures market closes, bond prices can move in the gap.
If bond prices fall after the close, the seller can buy bonds more cheaply and deliver them at the higher invoice price already locked in. If bond prices rise, the seller can simply decide not to deliver that day and wait for another chance.
That freedom to wait is why it is called an option. The seller has a free choice, and the buyer (the "long") has none, which means the buyer is effectively paying for the option indirectly through a slightly lower futures price.
The value is a small premium built into the market. Deliverable bonds are only one part of a wider set of seller options.
The seller can also choose which bond to deliver, known as the quality option, and when in the delivery month to deliver, known as the timing option. Together they form a package of delivery choices that traders try to value when pricing Treasury futures.
For non-specialists, the wild card option is mainly a useful example of how contract design creates hidden value. Anyone who sells or hedges with futures should know that the settlement rules favour one side in small ways.
Exchange rules and delivery times change, so the exact mechanics should always be checked in the current contract specification.
In practice
Real-world examples.
Example
A bond dealer holds a short position in Treasury futures at the end of the delivery period. News after the futures close pushes yields up and bond prices down, so the dealer buys the cheaper bonds and delivers at the earlier invoice price.
Example
A pension fund buys Treasury futures to extend its duration, meaning its sensitivity to interest rate changes. The portfolio manager notes that the futures price quoted includes a small discount because sellers hold the wild card option.
Example
A risk analyst at a bank values the delivery options inside its short futures book. She estimates the wild card option as a modest contribution compared with the quality option, but still includes it in the pricing model.
Formula
Calculation
Wild card gain per contract = Invoice amount fixed at settlement - Cost of the bonds bought after the close
Suppose a seller gives notice of delivery, and the invoice amount fixed at the futures settlement price is $108,000 per contract. After the futures market closes, bond prices fall, and the seller can buy the bonds needed for delivery in the cash market for $107,400. The gain is 108,000 - 107,400 = $600 per contract. On a delivery of 50 contracts, the seller gains 600 x 50 = $30,000.Case study
Seen in the real world.
Cedar Point Securities is a fictional broker-dealer used purely as an illustrative example. Its futures desk was short 200 Treasury contracts heading into the last delivery days. The desk head wanted to decide between delivering early and waiting.
On one day, the futures settled at a price implying an invoice amount of $110,000 per contract. After the close, an unexpected jobs report pushed bond prices up, so delivery that evening would have cost the desk more than the invoice amount. The desk chose not to deliver and waited a day, and on the next day it delivered after prices eased, saving about $300 per contract, or $60,000 across all 200 contracts.
Watch out
Common mistakes.
- Believing that the buyer of the futures contract also holds a wild card option, when it belongs to the seller only.
- Assuming the option can be exercised at any time of day, when it relies on the gap between the futures settlement and the delivery notice deadline.
- Treating the option as a large source of profit, when its value is usually small and competitive pricing tends to build it into the market.
Questions
People also ask.
Why is it called a wild card?
A wild card is a free choice that can be played at the best moment, and the seller gets to choose the moment after seeing how the bond market moves.
Does the option exist for all futures?
No, it is specific to contracts that have a daily settlement price and a later delivery notice window, such as US Treasury bond futures.
Who pays for the option?
The buyer does, indirectly, because futures prices are slightly lower to reflect the value of the seller's right.
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