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

Abstract

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...