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FRM Part I · FRM Exam Part I · Interest Rate Futures

Treasury bond futures conversion factors are computed by assuming a 6% yield for all deliverable bonds. If actual yields on all deliverable bonds are well above 6%, which type of bond is most likely to be cheapest to deliver?

A low-coupon bond with long maturity is most likely cheapest to deliver. When yields are above 6%, the conversion factors, based on a 6% yield, favour delivering bonds with the highest duration, which are low-coupon, long-maturity bonds. Their prices fall most relative to their conversion factors.

  1. AA high-coupon bond with short maturity
  2. BA high-coupon bond with long maturity
  3. CA low-coupon bond with long maturityCorrect
  4. DA low-coupon bond with short maturity

Explanation

When yields exceed 6%, the conversion factor system overstates the value of bonds less sensitive to yields, so delivery favours bonds whose prices have fallen most relative to their conversion factors. These are low-coupon, long-maturity bonds, which have the highest duration. High-coupon, short-maturity bonds are favoured when yields are below 6%.

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