An analysis of the true notional bond system applied to the CBOT T-bond futures

2012

Quantitative Finance

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The aim of this paper is to investigate the pricing of the Chicago Board of Trade (CBOT) Treasury-Bond futures. The difficulty in pricing it arises from its multiple inter-dependent embedded delivery options, which can be exercised at various times and dates during the delivery month. We consider a general Markov diffusion process model for stochastic interest rates and propose a pricing algorithm that can handle all the delivery rules embedded in the CBOT T-Bond futures. Our procedure combines dynamic programming, finite-elements approximation, and fixed-point evaluation. Numerical illustrations are provided under the one-factor Vasicek and Cox-Ingesoll-Ross models, and under the time in-homogeneous Hull-White model.

Section: Introductionmentioning

confidence: 99%

Pricing the Chicago Board of Trade T-Bond futures

Ben-Abdallah

Ben‐Ameur

2012

Quantitative Finance

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To Squeeze or Not to Squeeze? That Is No Longer the Question

Ben-Abdallah

Journal of Futures Markets

2015

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This paper provides an investigation into an anomaly called a short squeeze, in the CBOT T-Bonds Futures Market, for the period spanning January 1985 to December 2014. A short squeeze occurs when market manipulations cause the cheapest-to-deliver bond to be in short supply, resulting in significant price distortions. The incentive for market manipulation, or squeeze potential, is evaluated over the last 30 years and is related to documented episodes of the CBOT futures market. It is observed that conditions are presently very favorable to the occurrence of short squeezes, and that shortages would imply large losses for short traders. We also find that the incentive for market manipulation would be significantly reduced by lowering the notional underlying security coupon rate.

Time is money: An empirical investigation of delivery behavior in the U.S. T‐Bond futures market

Journal of Futures Markets

Ben-Abdallah²

2017

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Funding information NSERCThis paper analyzes the delivery behavior observed in the CBOT T-Bond futures market over the period spanning 1985-2016 in order to assess how timing decisions were made, and whether these decisions were optimal. During that period, delivery was generally deferred to the last possible moment, but early delivery episodes were also observed regularly. A regression model identifying the determinants of early exercise over the last three decades is proposed, along with a case-by-case analysis of specific delivery patterns. Finally, the optimality of the observed delivery strategies is assessed a posteriori. J E L C L A S S I F I C A T I O N C61, C63, G12, G13 | INTRODUCTIONThe Treasury Bond futures contract traded on the Chicago Board of Trade (CBOT T-Bond futures hereafter) is one of the most liquid, transparent, and actively traded futures contracts in the world, making it an instrument of choice for hedging long-term interest-rate-risk exposure. This contract calls for the delivery of the $100,000 face value of a long-term government bond bearing a 6% coupon rate. 1 Because the underlying notional bond does not generally trade in the marketplace, the short trader is offered the option to choose which bond to deliver among a deliverable set fixed by the exchange (the delivery basket). This delivery privilege is called the quality option. However, since the characteristics of the deliverable issues may differ substantially from those of the notional bond, and in order to make the delivery fair for both parties, the futures price received by the short trader is adjusted according to the quality of the T-Bond actually delivered. To do so, the CBOT uses a set of conversion factors, defined as the prices of the eligible T-Bonds computed on the first possible delivery day, under the assumption that the yield curve is flat at a level fixed at 6% per annum with semiannual compounding. This assumption is generally not representative of the market conditions, resulting in a conversion-factor-system bias that intensifies as the discrepancy widens between the assumed yield curve (flat at 6%) and the one currently observed. The conversion factor system thus fails to make eligible T-Bonds equal for delivery; the Treasury security that maximizes the short trader's economic profit is commonly known as the cheapest-to-deliver bond (CTD). 2 In the U.S. Treasury bond futures market, in addition to the quality option, short traders enjoy so-called timing 1 Prior to March 2000, the coupon rate of the notional bond was equal to 8% and has since then been reduced to 6%.2 For an in-depth discussion of the imperfections of the CBOT conversion-factor system, and the risk of and possible mitigations for conversion-factor risk, options, which allow them to deliver on any business day during a delivery month. 3 The quality and timing options offered to the short trader aim to alleviate the demand that would be triggered by the futures market on a single issue or on a single delivery day, thereby reducing the likeli...