BT Screencast- Cheapest to Deliver Bond

[notjusttp]

Hi David,

I went thru your screencast on Conversion price and Cheapest to deliver. Believe me its a beauty and u r a master magician as you unwind these concepts.

Thanks to your lucid explantion that I have only 1 doubt in this case

1) You say in the screencast that the short has a option to deliver any bond >15 yr mat so as to not hamper liquidity of any 1 single bond among various bonds available. i got this concept.

However when i checked the way you arrived at Cheapest to deliver bond, i got confused as to among the 3 given bonds you have illustrated in the screencast , the middle bond would always be Cheapest to deliver to any person in a short position and hence that bond would be highly liquid thus hampering the basic premise of doing all these calculations.

I am sure CBOE is pretty smart and i m missing some point but cant understand what. Appreciate your assistance as always.

Thanks & Best Regards
Amit :roll:

 

[David Harper CFA FRM]

Hi Amit,

Thank you for the kind f/back, truly....

In regard to hampering liquidity, that is exactly correct....The particular issue you raise has not occured to me, but my thought is: won't the bond prices adjust to prevent too much of a discrepancy? What i mean is, demand for the CTD bond will put upward pressure on its price so that it does not stray too far from the "next to CTD" bond ....
...as I look in Tuckman, please note the following (page 428-9, emphasis mine):

"The design of bond futures contracts purposely avoids a single underlying security. One reason for this is that if the single underlying bond should lose liquidity, perhaps because it has been accumulated over time by buy-and-hold investors and institutions, then the futures contract would lose its liquidity as well. Another reason for avoiding a single underlying bond is the possibility of a squeeze. To illustrate this problem, assume for the moment that only one bond were deliverable into a futures contract. Then a trader might be able to profit by simultaneously purchasing a large fraction of that bond issue and a large number of contracts. As parties with short positions in the contract scramble to buy that bond to deliver or scramble to buy back the contracts they have sold, the trader can sell the holding of both bonds and contracts at prices well above their fair values. But by making shorts hesitant to take positions, the threat of a squeeze can prevent a contract from attracting volume and liquidity.

The existence of a basket of securities effectively avoids the problems of a single deliverable only if the cost of delivering the next to CTD is not that much higher than the cost of delivering the CTD. In the example of Table 20.3, the difference between the cost of delivering the CTD and the cost of delivering the next to CTD is 32 cents. If a trader squeezes the 4.75s of November 15, 2008, then the most that can be extracted from shorts in the contract is 32 cents: If the trader tries to extract more, then shorts would purchase and deliver the 5.50s of May 15, 2009, instead."

David

 

[notjusttp]

Hi David,

Tks for the nice explanation. I had guessed the downward pressure on price as mentioned by you, however the quoted price ( as you calculated) was a function of yield and the cashflows of the 3 bonds, hence was not sure that market would adjust the price of CTD bond.

Can you pls clarify how Quoted price would change as the yield in market and the cashflow of the bonds remains the same so the cost to short would always remain constant theoretically?

Thanks Once Again
Amit

 

[David Harper CFA FRM]

Amit,

An excellent point (that truly demonstrates an understanding) but consider Tuckmans phrase, "the trader can sell the holding of both bonds and contracts at prices well above their fair values."

...my interpretation of Tuckman is, first he is saying that, by design, the basket of alternatives to the CTD should not be too much more expensive (e.g., in his example, $0.32 for the next CTD)...this would seem to be important b/c there must be viable alternatives...

...and, second, to your question, he is suggesting that arbitrage must keep the alternative bonds "in the hunt:" if the CTD is too cheap versus the next, then arbitrageurs can step in and profit at the short's (i.e., the one is delivering the bond) expense ... this is an issue of demand-and supply by the short and arbitrageurs ...

supply and demand are not (eghads!) included in our typical pricing model! Tuckman elsewhere discusses bonds that trade rich or trade cheap; for a bond to trade cheap is nothing more than for the market price to exceed the model price. This is a bit of reality for our model risk: we may use no arbitrage to price the bond, but the pricing is based on factors only in our model. If extra supply bids up the price (or dried up liquidity bids down the price), the market price reacts and deviates from our fair (read: model) price. Based on Tuckman's ideas, last year it occured to me to say "trading rich or trading cheap is evidence of model risk" ... in other words, if the price computed always matched the market price, there would be no trading rich/cheap.

... related, the yield (TYM) is a function of both the market (i.e., term structure of rates) and the bond instrument...so, as you say, we first look at a bond price of $X and determine, "the yield must be 6%." Then what if a bit of supply bumps up the price? Did the market yield drop or is the bond just trading rich? see my belabored point: the yield is "infected" by the the bond's mis-pricing vis a vis the model...but, i don't want to profess certainty on the CTD. Again, I honestly hadn never thought this CTD issue through as far as you have queried, i am merely trying to interpret Tuckman... David

 

[notjusttp]

David,

Phenomenal explanation..Model Risk is the right term to answer my question...You are just too good..Wish i had the vision, understanding and knowledge you possess...then FRM would have been a cake walk..Tks Once Again...Cheers..Amit