Cheapest to Deliver: Exploiting Futures Contract Mispricing

The "cheapest to deliver" (CTD) concept arises in the realm of physically delivered futures contracts, particularly those related to bonds and other commodities. It refers to the underlying asset that is most profitable for the short position holder (the seller) to deliver to fulfill their obligation upon the futures contract's expiration.

Futures contracts are agreements to buy or sell an asset at a predetermined price on a specified future date. When a futures contract nears its expiration, the short position holder must either close out their position or physically deliver the underlying asset to the long position holder (the buyer).

In many futures contracts, the short seller isn't limited to delivering a single, specific asset. Instead, a range of assets that meet certain criteria are eligible for delivery. For example, in a Treasury bond futures contract, the short seller can deliver any Treasury bond that meets the contract’s specifications regarding maturity date and coupon rate.

This flexibility leads to the CTD. The short seller will choose to deliver the asset that maximizes their profit. This asset is the one where the cost of acquiring it in the spot market, plus associated delivery costs, is less than the implied value they receive based on the futures price and the conversion factor specified by the exchange.

How to Calculate the CTD:

1. Identify Eligible Assets: Determine all the assets that meet the delivery requirements of the futures contract.
2. Calculate Implied Delivery Value: For each eligible asset, multiply the futures contract price by the asset's conversion factor. The conversion factor adjusts for differences in coupon rates and maturity dates among the deliverable assets.
3. Calculate Net Cost of Delivery: For each eligible asset, add the purchase price in the spot market to any associated costs (e.g., transportation, storage).
4. Determine the CTD: The CTD is the asset with the largest difference between its implied delivery value and its net cost of delivery. The short seller will deliver this asset to maximize their profit.

Trading Strategies and Implications:

• Anticipating Delivery: Traders can analyze market data to predict which asset will likely be the CTD. This information can be used to develop trading strategies that exploit potential mispricings.
• Arbitrage Opportunities: Discrepancies between the futures price, the spot price of the CTD, and the conversion factor can create arbitrage opportunities. Traders may simultaneously buy the CTD in the spot market and sell the futures contract, profiting from the price difference when they deliver the asset.
• Hedging Strategies: Understanding the CTD is crucial for effective hedging. Hedgers can choose to hedge with futures contracts expecting that the futures price will converge to the spot price of the CTD as the contract nears expiration.

Important Considerations:

• Conversion Factors: Accurate conversion factors are essential for determining the CTD. These factors are typically provided by the exchange and adjust for differences in the characteristics of the deliverable assets.
• Market Volatility: Changes in interest rates or other market factors can impact the relative value of the deliverable assets, potentially changing the CTD.
• Transaction Costs: Transaction costs, such as brokerage fees and transportation expenses, can affect the profitability of delivering a particular asset.

In conclusion, understanding the cheapest-to-deliver concept is vital for anyone trading or hedging with physically delivered futures contracts. Identifying and anticipating the CTD can reveal profitable trading opportunities and enhance risk management strategies. Careful analysis of market data, conversion factors, and transaction costs is essential for successfully navigating the complexities of the CTD.