The CTD bond has a price of 100000 and a conversion factor of 1.02.
What exactly is the conversion factor?
Thanks!
Cheapest-to-deliver (CTD) bonds have conversion factors that are based on the price that a deliverable bond would sell for at the beginning of the delivery month if it were to yield 6%. Conversion factors will be equal to one if the bond has a yield of 6%. If the bond has a yield > 6%, the conversion factor will be > 1. If the bond has a yield < 6%, the conversion factor will be < 1.
A bond yield of 6% is chosen because the underlying insturment for a Treasury bond futures contract is a $100K par value of a hypothetical 30-year, 6% coupon bond.
Hope this helps!
OMGMileyCyrus
If the bond has a yield of more than > 6% that means, the bond would be trading at below 100K and hence the conversion factor would be greater than 1 to make it equivalent to the 6% coupon bond?
Is that correct?
Yes.
The underlying on a T-bond futures contract is $100,000 par of a theoretical 20-year, 6%-coupon, noncallable bond. As there is no such bond in circulation, the deliverable can be any T-bond with at least 15 years to maturity (or first call if callable). As they won’t have the same market price as the theoretical bond, they have a conversion factor that adjusts the deliverable par value so that the resulting market price is (really, really close to) that of the theoretical bond.
As the conversion factors aren’t perfect (because prices change constantly), one such deliverable bond will be cheaper than each of the rest; it’s the cheapest-to-deliver.