Cheapest to Deliver bonds

[k_gopala]

Hi David,

Reference: Interest rate futures. Page 135 Hull.

Is it possible to have a negative value,while trying to select CTD bonds. ( Quoted Bond price- (Settlement Price *Conversion factor). If so, what does it convey intuitively.

Page 139.

I could not understand the two components to the difference between Euro dollar futures contract and FRA, as mentioned in the book. Can you please enlighten.

Thanks and regards

 

[David Harper CFA FRM]

On first, sure because there is nothing special about the zero/+/- here. It simply a formula to minimize cost/benefit. Hull's point is the trader, being self interested, wants to MINIMIZE[cost to buy the bond for delivery - benefit trader receives by delivering the same bond]. Differences here are largely driven by the conversion system, which assumes a 6% flat yield curve for pricing the CF (and some rounding). So, don't quote me on this, i haven't worked it thru (thought it would be easy to do with the XLS), but I *think* that negatives here will imply with higher market yields, above 6% (because higher market yields will drive down the quoted price but the CF system, stuck @ 6%, will not keep pace).

On the second, this is related to their different delta where you might get something out of this long thread. This (both, IMO) reduce to: with a futures contract, daily settlement implies a fluctuating margin account. That means marginal (excess/less) cash today instead of waiting until tomorrow for the forward. Forward on corn mean: your gain wait until later. Future on corn mean: daily settlement which means (i) volatility at the margin (cash in, cash out) and (ii) slightly more risk, which requires slightly higher rate (return) for a future vis a vis forward.

as i wrote to Ened, this convexity bias is connected to the difference in forward vs. future delta, so you can "kill two birds with one stone"

David