Can someone explain to me how Treasury Bond Futures work and how they are different from other bond futures? What exactly is the purpose of the conversion rate?
If I were to enter into a non-treasury bond future with a price of F0, at maturity I would pay F0 for the bond. But if I were to enter into a treasury bond future, why do I need to include accrued interest? Shouldn’t that already be factored into the contract price?
The underlying for a Treasury bond futures contract is a theoretical 20-year, 6% coupon T-bond. As there is no such bond in circulation, the short has the option to deliver any T-bond with at least 15 years left until maturity. Because these bonds will each be trading at their own price – none of which is likely to equal the price of the theoretical underlying – there is a conversion factor for each deliverable bond; the conversion attempts to adjust for the market price of that bond so that the number of such bonds delivered will have the same market value as the theoretical underlying.
However, the conversion factors are imperfect, primarily because the prices on the deliverable bonds are changing constantly. Thus, when combining the market price of each deliverable bond with its conversion factor, there will be a bond that is the cheapest of those available, and the short will select that bond to deliver; that bond is called – with no great originality – the cheapest-to-deliver (CTD) bond.
(I assume that by “maturity” you mean at the expiration of the futures contract, not at maturity of the underlying bonds.)
Generally, bonds are priced without accrued interest: the _ clean _ price; when bought or sold, the accrued interest is added to the clean price to arrive at the actual price paid: the _ dirty _ price. Although I’ve never traded bond futures, I see no reason that the underlying bonds should be treated any differently; i.e., the futures price will be the clean price of the bonds (alone), and the accrued interest will be added to arrive at the actual price paid. Frankly, I’d be quite surprised for them to be quoted any other way.
Thank you so much for the explanation! Great help!
My pleasure.