What Is Cheapest to Deliver?
Let me explain what 'cheapest to deliver' (CTD) means in the world of futures contracts. It's the cheapest security you can deliver to satisfy the terms of a futures contract if you're in the short position and handing it over to the long position. This concept only applies when the contract allows for a range of slightly different securities to be delivered.
You'll see this most often in Treasury bond futures contracts. These typically let you deliver any Treasury bond as long as it falls within a specific maturity range and has a certain coupon rate. Remember, the coupon rate is the interest rate the bond issuer pays out over the bond's entire term.
Key Takeaways
To keep it straightforward, cheapest to deliver is simply the least costly security that meets a futures contract's delivery requirements for the long position. It's a staple in Treasury bond futures. If you're in the short position, figuring out the CTD is crucial because there's often a gap between the security's market price and the conversion factor that determines its delivery value.
Understanding Cheapest to Deliver (CTD)
When you enter a futures contract, you're obligated as the buyer to purchase a specific quantity of an underlying financial instrument, and as the seller, you must deliver it on the agreed date. But if the contract doesn't specify an exact grade and multiple instruments could work, you as the short position holder get to choose the cheapest one to deliver.
Just a quick reminder: you take a short position when you sell an asset planning to buy it back cheaper later, usually because you expect the price to drop soon. Futures markets make it easy to go short anytime.
Why does CTD matter for the short side? There's frequently a difference between the market price of a security and the conversion factor used to value it for delivery. This difference lets you pick the most advantageous security to deliver. We generally assume the short position will always choose the CTD, so futures contract pricing in the market is based on that assumption.
Special Considerations
Choosing the CTD allows you, as the short position investor, to maximize your return or profit on the bond. Here's the basic calculation for CTD: it's the current bond price minus the settlement price multiplied by the conversion factor.
The current bond price includes the market price plus any accrued interest. But in practice, we often focus on the net earnings from the transaction, known as the implied repo rate. This is the return you get from selling a bond or futures contract and simultaneously buying the asset back at market price with borrowed money. A higher implied repo rate means the asset is cheaper to deliver overall.
The Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) set these conversion factors. They're there to account for different grades of securities and to prevent any unfair advantages in selection. These factors get adjusted as needed to ensure they're the most accurate for your calculations.
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