A Note On Interest Rate Futures

EXHIBIT VI

CHEAPEST TO DELIVER BOND

The seller may choose the bond to deliver from the bonds eligible for delivery. The factors which affect the bond yield include the bond price, the coupon, and the time until maturity. Therefore, bonds with coupons of 6% may not yield exactly 6%, but may be more or less than that. Five percent bonds yielding 6% necessarily sell for less than par, while 7% bonds yielding 6% sell for more than par. The conversion factor makes all bonds equally attractive for delivery only when the bonds under consideration yield 6%. If they yield more or less than 6%, one bond will have the lowest adjusted price, and hence be cheapest to deliver.

Since the party with the short position receives (quoted futures price X Conversion factor) + accrued interest

And his/her cost of purchasing the bond is quoted price + accrued interest

Therefore, the cheapest to deliver bond is the one for which Quoted price – (quoted futures price X Conversion factor) is the minimum

Example:

Bond	Quoted Price	Conversion Factor
1	98.50	1.2082
2	134.50	1.5588
3	128.75	1.3615

Given a quoted futures price of 93.25, the cost of delivering each of the bonds is:

Bond 1: 98.50 - (93.25×1.0182) = 3.55
Bond 2: 134.50 - (93.25×1.4088) = 3.12
Bond 3: 128.75 - (93.25×1.3485) = 3.00

The cheapest to deliver bond is bond 3.

Adapted from Strong A. Robert, Derivatives An Introduction, Hull C. John, Options, Futures and Other Derivatives,Financial Risk Management, IUP, www.cba.uiuc.edu

ADDITIONAL READINGS & REFERENCES:

1.John C. Hull., Options, Futures and Other Derivatives.
2.Robert A. Strong, Derivatives An Introduction
3.Financial Risk Management, IUP.
4.www.cme.com
5.www.wehner.tamu.edu
6.www.cba.uiuc.edu
7.www.jaring.my/mme/htm
8.www.forbes.com/tools/glossary