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Abstract
This paper examines an anomaly called short squeeze and its consequences in the Bund futures market. By short squeeze, in the present context, is meant a phenomenon caused by the shortage of the cheapest-to-deliver Bunds in the market to meet the delivery requirement of the futures contract. The squeeze may be created by market participants who see the opportunity to corner the market for underlying in order to drive up the price of both the underlying asset and the derivative contract. The investigation is conducted by examining measures of relative mispricing, the implied value of the quality option embedded in the futures contract and the cost of choosing the second cheapest-to-deliver Bund. The results show some evidence of occasional squeezes in the Bund futures market. More importantly, the conditions that corroborate the manipulative behaviour are discussed.
Notes
The Bund future embeds two delivery options, namely the quality option and the wild card option. The quality option allows the short parties to deliver any of the bonds in the deliverable basket and the wild card option gives the short parties an option to decide which bond to deliver until 7.00 p.m. CET at settlement price, which is established 12.30 p.m. CET.
The literature on the pricing of the quality option and other delivery options in the bond futures contracts is extensive, see for example: Bick (Citation1997), Boyle (Citation1989), Gay and Manaster (Citation1984) and Ritchken and Sankarasubramanian (Citation1992). An excellent survey is provided by Chance and Hemler (Citation1993).
The more homogeneous and larger the deliverable basket is, the smaller the value differences can become. This has been the case for the very liquid and active US Treasuries.
This is a simple rule in the futures markets, because it assumes that the cheapest deliverable bond is known and is not going to change. However, this approach is most widely used in the market and the aim is at recovering the behaviour of the market arbitrageurs in the situations investigated here.
Many papers discuss the pricing anomalies in the German government bond market and the associated futures contract: See: Shirreff (Citation1999), McCauley (Citation1999) and Upper (Citation2000).