2.2.4.1.3. Basis and Cheapest to Deliver
Now that we know how the futures contract is priced, we can begin to examine which securities are the most economical for the short seller of a T-bond futures contract to acquire for delivery.
Theoretically, the principal invoice price (adjusted futures price) should make the seller indifferent as to which security he chooses to deliver. In practice, things are not so simple. For example, changing market conditions will impact different securities in different ways. Since conversion factors are a static figure set at a single point in time under given market conditions, they cannot account for how a changing interest rate environment affects the deliverable securities.
A bond’s price sensitivity to small changes in its interest rate is called its duration. Two factors influence duration: the bond’s coupon rate and time to maturity. Bonds with lower coupon rates tend to have higher durations than bonds with higher coupon rates. Moreover, bonds with longer maturity tend to have higher durations than bonds with shorter maturities. Thus, a 1% change in a high yield bond has a lesser impact on its price than a 1% change in a low yield bond. Similarly, a 1% change will have a lesser impact on the price of a bond that matures in 2 years’ time than one that matures in 16 years, because the impact of that 1% change grows as it compounds over time.
|
Characteristics of Bond Duration |
|||
|
Duration |
Maturity |
Coupon Rate |
Price Sensitivity |
|
High |
Longer |
Low rate |
More sensitive |
|
Low |
Shorter |
High rate |
Less sensitive |
If a low-duration bond is less sensitiv