Question

The December 10-year US Treasury note is currently priced at $127. The following bonds are eligible for delivery into the contract with the following conversion factors. Please calculate the delivery prices for each bond ignoring accrued interest:

2% of 11/26 CF=.75        _______________________

2.25% of 2/27 CF=.76     _______________________

2.375% of 5/27 CF=.77   _______________________

What additional information do you need to figure out which bond from #4 is the “cheapest-to-deliver?”

If you are trading the 10-year Treasury futures contract, why is it important to know what bond is “cheapest-to-deliver?”

Answer 1

Answer 1.

Cheapest to Deliver - CTD'

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.

A futures contract enters the buyer into an obligation to purchase a specific quantity of a particular underlying financial instrument. The seller must deliver the underlying on a date specified. In cases where multiple financial instruments can satisfy the contract based on the fact that a particular grade was not specified, the seller holding the short position can identify which instrument will be the cheapest to deliver.

Selecting the cheapest to deliver provides the investor in the short position the ability to maximize his return, or profit, on the bond chosen. The calculation to determine the cheapest to deliver is:

CTD = Current Bond Price – Settlement Price x Conversion Factor

The current bond price is determine based on the current market price with any interest due added to reach a total. Additionally, the calculations are more commonly based on the net amount earned from the transaction, also known as the implied repo rate. Higher implied repo rates result in assets that are cheaper to deliver overall.

Set by the Chicago Board of Trade, the Chicago Mercantile Exchange Group, the conversion factor is required in order to adjust for the varying grades that may be under consideration and is designed to limit certain advantages that may exist when selecting between multiple options. The conversion factors are adjusted as necessary to provide the most useful metric when using the information for calculations.

Answer 2.

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.

Because the short position has various bond options in delivering on the futures contract there is a optimal choice that will provide the biggest profits. The cheapest to deliver bond is the one that minimizes the difference between the cost to acquire the bond less the proceeds from delivery bond.

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