What Is Cheapest to Deliver?

In the realm of futures contracts, the term “cheapest to deliver” (CTD) denotes the most cost-effective security that can be delivered to fulfill the obligations of a long position as outlined in the contract. This concept comes into play particularly in contracts where a range of similar securities can be utilized for delivery.

A prime example of this scenario is evident in Treasury bond futures contracts, where any treasury bond within certain maturity and coupon rate criteria can be delivered. The coupon rate refers to the issuer’s interest rate for the duration of the bond’s term.

Key Takeaways:

• Cheapest to deliver refers to the most economical security that can be delivered to fulfill a futures contract’s requirements.
• This concept is prevalent in Treasury bond futures contracts.
• Identifying the cheapest to deliver security is critical for the short position due to discrepancies between a security’s market price and its conversion factor, which determines its value.

Understanding Cheapest to Deliver (CTD)

When engaging in a futures contract, the buyer commits to acquiring a specified quantity of an underlying financial instrument, with the seller obligated to deliver the security on an agreed-upon date. In instances where several securities could fulfill the contract parameters due to lack of specificity, the seller in the short position must pinpoint the most cost-effective security to deliver.

Traders typically assume a short position when selling an asset with the intention of buying it back at a lower price later, usually anticipating a price decline. Futures markets facilitate short positions at any time.

Determining the cheapest to deliver security is crucial for the short position due to pricing differences and the advantage of selecting a specific security over others. As the market generally values futures contracts based on the cheapest to deliver security, the short position is presumed to offer this cost-effective option.

There is a general assumption that the short position provides the cheapest to deliver security.

Special Considerations

Opting for the cheapest to deliver security empowers the investor in the short position to optimize their returns on the chosen bond. The formula for calculating the cheapest to deliver is:

CTD = Current Bond Price – Settlement Price x Conversion Factor

The current bond price is derived from the market price plus any accrued interest. Calculations often revolve around the net transaction amount, known as the implied repo rate—a return rate a trader can realize by selling a bond or futures contract and simultaneously buying the same asset at market price with borrowed funds. Higher implied repo rates translate to more cost-effective delivery assets.

Regulated by the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME), the conversion factor adjusts for varying grades to prevent advantages when choosing between options. These factors are periodically adjusted for increased accuracy in calculations.