Bond futures, cheapest-to-deliver bond.

CFA Level III
#1

I have been trying to understand how this whole thing works.

I’m thinking, that the cheapest-to-deliver bond (CTD) is not determined till the day futures expires when delivery is in order. But it’s pointed out that futures price is determined as “price of CTD / conversion factor”. So how to price futures in the days leading up to expiration? I think futures price should be independent of CTD; and the money that long party pays is equal to “futures price x conversion factor”.

Anyone who actually has practical experience and knows how this works along a futures timeline? Would really need your enlightenment. Thank ya!

#2

It’s been a while but I think

Although one cannot know with absolute certainty what will be CTD on expiry day, one can see what is CTD at current yields very easily. Using Bloomberg you can also perform scenario analysis to see which bond is CTD under various parallel shifts in the yield curve. CTD is generally established by backing out the implied repo. The bond with the highest implied repo is CTD. One would generally use Bloomberg for this analysis. At the moment looking at the front 10y futures it shows that 3 1/8 05/19 is the cheapest and would still be cheapest even if the yield curve shifted up or down 50bps. That’s pretty close to a sure thing. As far as I remember and it’s been a while since I’ve seen it, if there are 2 bonds that are potential CTD, you assign a probability to each and use that as a multiplier with each bonds conversion factor.

#3

Thanks, ellergy, for the real-life example.

While one may foresee with a good deal of certainty what’s going to be CTD, what’s wrong with pricing futures based solely on the underlying bond?

#4

Well firstly it’s not always as easy to identify the CTD so there’s that. Secondly is you had a future based on just one bond then the tenor you’re trading is going to change the closer you get to maturity. What was a 10y becomes a 5y. It would also make you very exposed to things like the bond going special in repo. The conversion factor exists to convert the bond to yield 6% which is the standard for the contract.

#5

Mmm… interesting.

#6

There are multiple underlying bonds that qualify to be delivered for a 10 year T-Note futures contract that expires in Sept of 2012. One might be a 30 year bond issued 20 years ago with a coupon of 3%. Another one could be a 15 year bond that was issued around 5 years ago. All the bonds that qualify have about the same time to maturity but there is still some deviation there. Daily each bond can be priced. The one that is the cheapest one is the CTD bond. If you want to accurately estimate duration of the futures contract, you have to price individual bonds under different scenarios.