Callable U.S. Treasury Bonds: Optimal Calls, Anomalies, and Implied Volatilities

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Abstract
Using implied volatility analysis, this article addresses two important issues concerning callable bonds: negative option value anomalies and the optimal call decision rule. In examining apparent negative option values embedded in callable U.S. Treasury bonds, we significantly extend the sample periods and breadths covered by previous researchers and resolve the inconsistencies in their results. We show that the frequency of negative option values is time‐varying and related to away‐from‐the‐moneyness. We then develop the option‐theoretic optimal policy for calling bonds by introducing the concept of “threshold volatility.” Using the concept we determine that most past Treasury call decisions were optimal.

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