1
$\begingroup$

What is the logic behind using the conversion factor in determining the hedge ratio of deliverable bonds in 30Yr UST futures (WN contracts) throughout the trading life of the contract, but then having a 1:1 ratio in actual delivery of the bond to the long futures holder in physical delivery period and therefore leaving a tail?

Edit to clarify my question:

If the deliverable bonds are specified at the onset of the contract, and a conversion factor is determined to make the deliverable bonds an equivalent yield, why does the conversion factor not follow into the delivery period? It would seem that if the notional amount of bonds to be delivered should be the inverse of the conversion factor for the bonds that are delivered; thus eliminating the requirement to trade the hedge tail at delivery. Why did the exchange specify the 1:1 ratio for delivery, rather the inverse of the conversion factor into the contract?

Improve this question
$\endgroup$

1 Answer 1

Reset to default
2
$\begingroup$

Due to the existence of the conversion factor the futures price does not move 1:1 with the bond, so a position in a notional 1mm bonds and a notional 1mm futures will gain or lose PnL as market yields move around. Thus, in the trading phase the trader needs to hold the correct amount of futures in order that market yield movements does not gain or lose PnL. The conversion factor determines the weighting.

When it comes to settlement the futures holder will accept delivery of the bonds and his short position will net out, he will only receive 1mm bonds for every 1mm notional futures position. Thus, as the contract goes to settlement the trader needs to close any residual futures positions at the exchange delivery settlement price to remain completely hedged. Failure to do this results in the trader having a residual futures position after settlement which will gain or lose PnL as the market continues to evolve.

Improve this answer
$\endgroup$
2
  • $\begingroup$ Thanks very much for your response. I guess my question is really why doesn't the delivery of the bond use the conversion factor as well? It seems to me that if it did, the hedges during the life of the contract would follow into the delivery period and therefore not require the tail to be traded on delivery. $\endgroup$
    – AlRacoon
    Commented Feb 3 at 17:18
  • $\begingroup$ The conversion factor is an adjustment used to standardise the price of the future relative to different bonds with different maturities and coupons in the basket. This settlement phenomena comes about as a result of that defined specification. If the specification of the contract was changed to what you suggest I am not convinced that it would work in a practical situation. Even if it did work practically there may well be equally undesirable properties (or worse) of a different form that would also be questionable. I don't know if there is a better solution, but I suspect maybe not. $\endgroup$
    – Attack68 ♦
    Commented Feb 3 at 18:47

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.