Why is the cheapest bond to deliver the chosen bond to deliver? When I ask this, it says that the bond with the highest cash flows are the bonds that should be delivered and considered “cheapest.” I understand they are cheapest in the point of view of the person going long futures, but if you held a high yielding asset, wouldn’t you want to keep it and not deliver it? I would certainly want to deliver the lowest yielding asset.
Presumably, the short will purchase the bonds, then deliver them to the long. The short will choose the bonds with the lowest price – the cheapest bonds, if you will – to deliver to the long; hence: cheapest to deliver. Short maximizes his return that way.
Got it. Thanks magician
My pleasure.
But what if this is supposed to be a cash settlement and the protection seller doesn’t have to buy the bond at all? In that case the short will be paying the difference between par value and recovery value. So if a bond is trading at 20% and another at 30% , wouldn’t the short prefer 30% bond cause he only needs to pay 70% as against 80% in first case?
We were discussing bond futures, not CDSs.
For CDSs, the protection seller would definitely prefer paying off on a bond selling at 30% to one selling at 20%. But the protection seller doesn’t have that option; they’re contractually obligated to pay off on the CTD bond.
Thanks!
You’re quite welcome.