Treasury bond futures
Intro: In this small work I will present how to find the cheapest to deliver bond and manually compute
the conversion factor for bond futures.
Quotations
Treasury bond and treasury futures notes are quoted in dollars and thirty-seconds of a dollar per 100$
of face value. This is similar to the way bonds are notes are quoted in the spot market.
15.0
If the settlement price of a treasury futures contract is 124 − 150 that translates into 124 =
32
124.46875
Conversion factors
Conversion factor = Clean price (Quoted price)/Face Value where the clean price is computed
considering a 6% yield semi-annual coupon bond.
When a particular bond is delivered in a bond futures contract, a parameter known as its conversion
factor defines the price received for the bond by the party with the short position.
The applicable quoted price is the product of the conversion factor and the most-recent settlement
price for the futures contract. If we take into account the accrued interest, the cash received for each
100$ face value of the bond is Most recent settlement price x Conversion factor + Accrued Interest.
Example 1:
Suppose we have a newly issued bond with maturity 10 years, the coupon is 5%.
2.5 2.5 2.5 102.5
The price of the bond is 1 + 1.061 + ⋯ + 1.069.5 + 1.0610 = 91.9190
1.062
91.9190
The conversion factor is = 0.919190.
100
Example 2:
Suppose we have a 3-month old bond with the same maturity and parameters above.
2.5 2.5 102.5
The price of the bond in 3 months is 2.5 + 1 + 1.061 + ⋯ + 1.069.5 = 94.7183.
1.062
94.7183 5
The full price now is 1 = 93.3485. The clean price is 93.3485 − 4 = 92.0985.
1.064
The conversion factor is 0.920985.
Example 3:
Suppose the most recent settlement price of a 6% annually payable coupon bond is 90-25, the
conversion factor is 1.38 and the last coupon date was 4 months ago, then:
4
𝐴𝐼(𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) = 12 ⋅ 6 = 2, the cash paid to the party being short on the futures contract, at
25
delivery is 1.38 × 90 32 + 2 = 127.2781.
Cheapest-to-deliver bond
In a bond futures price, the party with the short position receives (Most recent settlement price x
Conversion price) + Accrued and the cost of purchasing bond is Quoted bond price + Accrued interest.
Therefore the net cost to the party holding the short position is Quoted bond price – (Most recent
settlement price x conversion price).
The rule is to choose the bond that has the minimum net cost.
Example 1:
The party with the short position decides to deliver a bond and is trying to choose between the three
bonds below. Assume the most recent settlement price is 97-08.
Bond Quoted price ($) Conversion factor
Bond 1 99.50 1.1231
Bond 2 121.50 1.2421
Bond 3 109.50 1.0971
The cost of delivering each of these bonds is as follows:
Bond 1: 99.50 – 97.25 x 1.1231 = -9.721475
Bond 2: 121.50 – 97.25 x 1.2421 = 0.7057
Bond 3: 109.50 – 97.25 x 1.0971 = 2.8070
The cheapest bond is bond 1. Actually the short site would receive 9.72$ for every 100$ of face value.
Exercise 1:
1
Suppose a default-free bond issued 6 months ago has a remaining maturity of 3 2 years, annually
coupons payable at 8% level. Suppose the spot rates at this time are given in the following table:
1 year 3%
2 years 3.5%
3 years 4%
5 years 5%
Find the conversion factor of that bond.
Solution to exercise 1:
1 1 1 1
We need to use an approximate spot rate for 2 , 1,1 2 , 2,2 2 , 3,3 2 year terms which are 1.5%, 3%, 3.25%,
4 4 4 4 4 4 104
3.5%, 3.75%, 4%, 4.25%. So the full price is 1 + 1.03 + 3 + 1.0352 + 5 + 1.043 + 7 =
1.0152 1.03252 1.03752 1.04252
112.5063
The clean price is: 112.5063 − 4 = 108.5063 so the conversion factor is 1.085063.
Exercise 2:
We want to choose from the following 2 bonds to immediately deliver in a futures bond contract.
Bond 1: 2 years maturity, 4% coupon, quoted price = 101.60
Bond 2: 2.5 years maturity, 5% coupon, quoted price = 100.60
The last settlement price was 98-05. Find the cheapest to deliver bond.
Solution to exercise 2:
2 2 2 102
1 +1.06+ 3 +1.062
1.062 1.062
The conversion factor to bond 1 is: 𝐶𝐹1 = 100
= 0.9644
2.5 2.5 2.5 2.5 102.5
1 +1.06+ 3 +1.062 + 5
1.062 1.062 1.062
The conversion factor to bond 2 is: 𝐶𝐹2 = 100
= 0.9790
Now the cost to deliver in first case is: Quoted bond price 1 – Most recent settlement price x conversion
factor 1 = 101.60 – 98.15625 x 0.9644 = 6.9381
The cost to deliver for bond 2 is: 100.60 – 98.15625 x 0.9790 = 4.5050
The cheapest to deliver bond is the bond number 2.
