What Is the ‘Cheapest to Deliver’ Strategy?
The term ‘cheapest to deliver’ (CTD) refers to the least expensive security delivered in a futures contract to a long position to meet the contract’s specifications. This scenario is common in Treasury bond futures contracts where any Treasury bond within a certain maturity range and coupon rate can be delivered. The coupon rate reflects the interest a bond issuer pays over the security’s term.
Key Takeaways
- The ‘cheapest to deliver’ is the least expensive security delivered in a futures contract.
- Commonly used in Treasury bond futures contracts.
- Crucial for the short position as market price differences and conversion factors impact the value determination.
Understanding the ‘Cheapest to Deliver’ (CTD)
A futures contract obligates the buyer to purchase a specific amount of a financial instrument, while the seller must deliver the security on an agreed date. When contracts allow multiple financial instruments to satisfy their terms, the seller with a short position can select the cheapest to deliver.
In trading, taking a short position means selling an asset to repurchase it at a lower price later, leveraging predicted price drops. Futures markets enable traders to take short positions any time.
The cheapest to deliver choice is essential for the short position. It allows the seller to deliver a specific security over another, thereby maximizing profit. Futures markets usually base pricing on the assumption that the short position provides the cheapest to deliver security.
Special Considerations
Opting for the cheapest to deliver allows short position investors to maximize their return or profit. The equation for determining the cheapest to deliver is: CTD = Current Bond Price - (Settlement Price x Conversion Factor)
The current bond price adds any interest due to calculate the total. This calculation also often references the net amount earned from the transaction, known as the implied repo rate—a measure of return when selling a bond or futures contract and buying the same asset with borrowed funds simultaneously. Higher implied repo rates make assets cheaper to deliver.
Set by entities like the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME), the conversion factor adjusts for varying securities’ differences and aims to balance any favorable conditions when choosing among multiple options. Conversion factors are frequently updated to maintain fair calculations.
By understanding and employing the cheapest to deliver strategy, traders can unlock hidden profits and sharpen their trading strategy to adapt to changing market conditions.
Related Terms: futures contract, short position, conversion factor, implied repo rate.
