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I am not familiar enough with the theories of option pricing to understand how negative option prices are possible. I found two research papers indicating that negative option prices are indeed possible for callable US treasury bonds:

Can someone explain why negative option prices are possible for callable US treasury bonds?

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  • $\begingroup$ Interesting. But FWIW all USTR bonds nowadays are not callable. $\endgroup$
    – nbbo2
    May 4, 2020 at 10:35
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    $\begingroup$ An actual option with an independent existence cannot have a negative price. But we are talking here about 'embedded options' that are part of another security (in this case a USTR bond) and cannot be separated from their parent. Their price is not quoted in the marketplace but is found by a calculation. The problem is that this calculation comes up with a negative number. It is more an ANOMALY IN BOND PRICING than a fact about options. The bond pricing takes other considerations into account that completely overwhelm the embedded optionality and make the calculation come out the way it does. $\endgroup$
    – nbbo2
    May 4, 2020 at 13:46
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    $\begingroup$ It shows the Embedded Option approach to security valuation does not always work.Because there could be another component of price which we have forgotten to include. $\endgroup$
    – nbbo2
    May 4, 2020 at 13:47
  • $\begingroup$ @noob2 Your comments are helpful. Please copy them into an answer. $\endgroup$
    – Flux
    Jul 29, 2021 at 7:19

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An actual option with an independent existence cannot have a negative price. But we are talking here about 'embedded options' that are part of another security (in this case a USTR bond) and cannot be separated from their parent. Their price is not quoted in the marketplace but is found by a calculation. The problem is that this calculation comes up with a negative number. It is more an ANOMALY IN BOND PRICING than a fact about options. The bond pricing takes other considerations into account that completely overwhelm the embedded optionality and make the calculation come out the way it does.

It shows the Embedded Option approach to security valuation does not always work. Because there could be another component of price which we have forgotten to include (an omitted component).

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