Question

What are conversion factors? How do they impact on which bond is cheapest to deliver? Under what conditions would there be no cheapest to deliver?

Answer 1

The conversion factor is the price of the delivered bond/note ($1 par value) to yield a fixed rate.  The conversion factor is used to calculate a final delivery price.A factor used to equate the price of T-bond and T-note futures contracts with the various cash T-bonds and T-notes eligible for delivery.

Cheapest to deliver (CTD) in a futures contract is the cheapest security that can be delivered to the long position to satisfy the contract specifications and is relevant only for contracts that allow a variety of slightly different securities to be delivered. This is common in treasury bond futures contracts, which typically specify that any treasury bond can be delivered so long as it is within a certain maturity range and has a certain coupon rate.

The lowest cost bond among possible bond delivery options that can be used to satisfy the short positions contractual obligations on a bond futures contract. On bond futures contracts the party with the short position in the futures contract typically has multiple options of delivery (vary on coupon payments, maturities) to satisfy the conditions of the contract, where the cheapest to deliver bond is the bond that maximizes the return for the short position.

Cheapest to deliver bond = Quoted Bond Price (to be delivered) - Settlement Price x Conversion Factor

When the conversion factor is in proportion of quoted bond price and settlement price then there might be the case of no cheapest to deliver.