Hi there,
I have a related question on conversion factor. It is in section 6.2 of Hull's book (9th-global). It says that if the short side decides to deliver the bond, then the cash to receive is "the product of the conversion factor and
the most recent settlement price for the futures contract".
My questions are
Settlement price is for daily mark to market. Right?
If delivery is taken, then it should be the locked-in price (i.e. F_0) at the issue of futures contract that is paid instead of the most recent settlement price. Right?
I guess I am missing something here. Could anyone help clarify, please?
It also says that "When bond yields are in excess of 6%, the conversion factor system tends to favor the delivery of
low-coupon long-maturity bonds". Can I interpret this as follows? I don't get the point on "low-coupon".
The bigger the conversion factor is, the better (everything else being the same);
If the bond yield is higher than 6% (e.g. 8%), then the conversion factor will be higher then the market price (lower discounting rate being used for the calculation of conversion factor); Note this is regardless of coupon or maturity.
For two bonds which are only different in terms of maturity, the longer-maturity will have longer duration. Hence, when discount rate changes from 8% to 6%, the longer-maturity bond will see bigger increase in price and conversion factor.
For two bonds which are only different in terms of coupon rate, the bigger the coupon rate, the higher the price and the higher the conversion factor. But why the text says it should be low-coupon?
Thank you!
Regards,
Xu
Click to expand...
Hi Xu,
For your first question, it seems to me that all the mark to market gains/losses up until now would have been reflected in the margin account of the person with the short position. Hence the most recent settlement price is used instead of the locked in price.
For your second question, I would interpret as follows:
The important factor in determining the CTD Bond is the percentage change in price between bond price calculated at current implied yields and the exchange specified yield of 6%. For a higher coupon bond, its duration will be lower than a corresponding lower coupon bond since the payment would be weighted more towards the end of the term for the lower coupon bond.
This would imply higher percentage change in price for the low coupon bond (Approximate % change in price is Duration * change in yield).
Hence when yields are in excess of 6% low coupon bonds are favored.
Last edited by a moderator: Oct 26, 2019