An Overlooked Coupon Effect in Treasury Futures Contracts

Abstract

Contracts for futures and other derivatives that allow physical delivery must specify a set of deliverable instruments in order to limit the possibility of squeezes in the cash market. But this invariably leads to one or a small number of them becoming “cheapest to deliver” (CTD). Seemingly minor factors in the contract specs can make a lot of difference to which instrument will be CTD. In this article, Grieves and Mann examine the Chicago Board of Trade's practice of computing delivery factors for its Treasury bond and Treasury note contracts by rounding each deliverable bond's maturity down to the nearest quarter of a year. This accelerates the predictable “pull to par” effect for bonds that are selling away from par, and also creates a subtle effect related to the bond's coupon rate. The well-known principle that when market yields are above (below) the coupon rate on the reference bond, currently 6%, long (short) duration bonds will be CTD must be modified to account for the coupon effect when yields are close to 6%.