Bond futures

Discussion in 'CT2' started by Scotty, May 28, 2011.

  1. Scotty

    Scotty Member

    Hey,

    Can someone explain to me about the delivery of a bond future. I don't understand what the notes are getting at. Why would one piece of paper be cheaper to deliver than another?...unless of course it weighs more...

    Many thanks

    Scotty
     
    Scotty, May 28, 2011
    #1
  2. Simon James

    Simon James ActEd Tutor Staff Member

    Hi Scotty. Which bit of the notes are you referring to? In general there are a surprising number of people (and hence cost) involved in delivering any asset - especially physically assets. Paper needs to change hands securely, deals need to be verified, payment needs to be made/received & accounted for, registers may need to be updated etc. Some bonds are now registered electronically and hence can change hands electronically which makes things cheaper.

    Hope this helps, let me know if not...!
    Simon
     
    Simon James, Jun 6, 2011
    #2
  3. Vorplex

    Vorplex Member

    Suspect Scotty is referring to CT2 Chapter 5 Section 1.2 where in the notes the phrase 'cheapest to deliver' is in italics presumably for emphasis, yet no further explanation given.
     
    Vorplex, Jul 8, 2011
    #3
  4. Scotty

    Scotty Member

    Exactly Vorplex. I just don't see why they would mention it and then not explain it - but I suppose it can't be that important for this course. Simon's explanation does provide a bit more insight though, so thank you.
     
    Scotty, Jul 18, 2011
    #4
  5. Calum

    Calum Member

    Isn't the cheapest-to-deliver issue down to the fact that for futures contracts, the PVs of available bonds are calculated using a fixed yield curve, meaning that the actual PV is slightly different - and hence some will be cheaper to deliver than others, even though they are in fulfilment of the same contract?
     
    Calum, Jul 19, 2011
    #5
  6. kylie jane

    kylie jane Member

    I kind of get what you are saying Calum, but I'm still a little confused. The comment from chapter 5 section 1.2 is: "The party delivering the bond will choose the stock from the list which is cheapest to deliver" My questions in regard to this are:

    1. Will this choice only exist if the stock isn't specified in the contract? So the example that they give below the bond futures definition, which is
    Unit of trading: £100,000 nominal value government bonds​
    means that the party delivering the bond won't have a choice here.

    2. With regard to the pricing mentioned below, could you go into more detail, is this only if the choice/term of the bond isn't specified? Wouldn't the term have to be specified so the future could be correctly priced?
     
    kylie jane, Mar 5, 2012
    #6
  7. Simon James

    Simon James ActEd Tutor Staff Member

    Some derivative contracts specify the exact product that the seller must deliver.

    However, some may have a broader specification, in which case the seller has the right to deliver any product that fulfills the requirements of the contract.

    In such a case, a rational seller will always choose to deliver the cheapest option, "the CTD". This may be a product of lower quality, and the price of a futures contract will reflect the fact that the seller will do this.

    For example, in a US 30-year Treasury bond future traded in Chicago*, the seller (short position) must deliver a Treasury bond with at least 15 years to maturity. Because these bonds have different values, the bond future contract is standardised by computing a conversion factor that normalises the price of a bond to a theoretical bond with a coupon of 6%.

    On expiry, if the contract is delivered, the seller will deliver the cheapest possible bond that meets the criteria.

    I hope this helps

    Simon

    PS this sort of detail is beyond the CT2 syllabus

    *If interested, the precise definition from the CME is:
    U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a remaining term to maturity of at least 15 years from the first day of the delivery month. Note: Beginning with the March 2011 expiry, the deliverable grade for T-Bond futures will be bonds with remaining maturity of at least 15 years, but less than 25 years, from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.
     
    Last edited: Mar 6, 2012
    Simon James, Mar 6, 2012
    #7

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