he underlying asset on a Treasury-bond futures contract in the Chicago T Board of Trade (CBT) is not a real asset, but is rather a hypothetical 15-yearmaturity government bond bearing an 8% coupon. Because the contract is settled using actual government bonds, the CBT is required to establish conversion factors which relate the settlement in terms of actual bonds to the benchmark asset. These factors are established by imperfect rules of thumb, however, and create basis risk for a hedger in T-bond futures, because the amount of money required to settle the contract and the profits or losses on the contract will depend upon the bond used as the delivery vehicle. The delivering short-side trader can choose to settle the contract with the bond which maximizes his profits. When future interest rates are stochastic and many bonds are eligible as delivery vehicles, neither the bond which actually will be chosen nor the conversion factor can be determined with certainty at the time the contract is established. Kilcollin (1982) investigates the prevailing delivery rules in the CBT and the New York Futures Exchange (NYFE) and concludes that the uncertainty about the delivery instrument affects equilibrium futures prices.
In this article we examine the extent to which conversion factor risk can affect the variability of returns on a futures contract. We also suggest a minor change in the procedure by which contracts are settled which can substantially reduce the magnitude of conversion factor risk. Our suggested procedure requires no computations beyond those already performed by the CBT and can significantly increase the efficacy of the T-bond futures market as a means of hedging interest rate risk.
In the next section we describe the process by which T-bond futures contracts are settled. We demonstrate the effects of conversion factor risk and suggest a way to mitigate that risk. In Section I1 we illustrate thk range of the magnitude of conversion factor risk in simulations based on hypothetical term structures. The results indicate that our suggestion for contract settlement can substantially decrease rate-ofreturn variability. Section I11 concludes.