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

Treasury bond futures use conversion factors computed as if all deliverable bonds yield 6% per year. When market yields for all maturities are well above 6%, which type of deliverable bond is most likely to be cheapest to deliver?

Low-coupon bonds with long maturity are most likely cheapest to deliver. When yields exceed the 6% conversion assumption, the conversion factor system favors high-duration bonds, which are those with low coupons and long maturities. When yields are below 6%, the reverse applies.

  1. ALow-coupon bonds with long maturityCorrect
  2. BHigh-coupon bonds with short maturity
  3. CHigh-coupon bonds with long maturity
  4. DBonds trading nearest to par, regardless of duration

Explanation

When yields exceed 6%, the conversion factor system overvalues bonds with low duration relative to their true price, so the cheapest bond to deliver tends to be the one with the lowest duration... The standard result is the reverse: when yields are above 6%, bonds with low coupons and long maturities (high duration) are favored because the conversion factor overstates their delivery price less than it overstates others. Thus low-coupon, long-maturity bonds tend to be cheapest to deliver.

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