Conversion factor risk in treasury bond futures: Comment

✍ Scribed by Robert A. Jones

• Publisher: John Wiley and Sons
• Year: 1985
• Tongue: English
• Weight: 309 KB
• Volume: 5
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.3990050112

✦ Synopsis

n a recent article, Alex Kane and Alan Marcus (1984) examine the implications I of delivery alternatives available to a short-side trader in the Chicago Board of Trade (CBT) Treasury bond futures contract. They conclude that the associated "conversion factor risk" significantly reduces the equilibrium futures price, and diminishes the contract's usefulness for hedging. They then suggest a modification to delivery procedures that could reduce these effects.

This note has two objectives. The first is to point out the irrelevance of the Kane-Marcus modification for the price of marked-to-market futures contracts. The simulations they perform for the modified contract are in fact appropriate for the currently traded contract. The second is to develop the notion that, in a world without tax effects, the price of the CBT contract is essentially determined by the deliverable bonds with the highest and the lowest durations. This allows the existing futures contract to be represented as a futures contract without delivery options, plus a call option. The value of this call option is calculated for the scenarios considered by Kane and Marcus.