Corporation Finance Final Exam Spring 2014
1.What are conversion factors? Why were conversion factors developed? How do they impact on which bond is cheapest to deliver? Under what conditions would there be no cheapest to deliver? Explain in detail. The conversion factor, for any particular bond deliverable into a futures contract is a number by which the bond future delivery settlement price is multiplied, to arrive at the delivery price for that bond. Conversion factor relates all outstanding deliverable government bonds and notes in terms of the nominal 6% bond specified in the contract. The formula to find conversion factor is as follows:
Conversion factors were developed by the CBOT in 1970's and was intended to compensate for the coupon and timing differences of deliverable bonds
The seller is able to choose which of the deliverable bonds he will deliver. Because he will always choose to deliver whichever bond is the cheapest for him to do so, this give rise to the concept of the cheapest to deliver bonds (CTD). The CTD bond is the one which is most cost effective for the future sellers to deliver to the buyer if required to do so. Arbitrage between cash and futures will ensure that there will be no profit from delivering the CTD bond, but there will be a loss from delivering any other qualifying bond. This is why the CTD concept is very important.
If the yield curve is flat and the YTM is 6% across all maturities, then the conversion factors will be proportional to market price. It is under this condition where there will be no cheapest to deliver. However, we know that the yield curve is no flat, therefore the conversion factor will make it more desirable to deliver a particular bond.
2. What information do we discover when we look at the June13 S&P 500 futures price and the Sept13 S&P 500 futures price? Explain in detail.
If we are given the price of 2 S &P 500 future contracts of different durations, we can find out what t he expected dividend yield would be
Conversion factors were developed by the CBOT in 1970's and was intended to compensate for the coupon and timing differences of deliverable bonds
The seller is able to choose which of the deliverable bonds he will deliver. Because he will always choose to deliver whichever bond is the cheapest for him to do so, this give rise to the concept of the cheapest to deliver bonds (CTD). The CTD bond is the one which is most cost effective for the future sellers to deliver to the buyer if required to do so. Arbitrage between cash and futures will ensure that there will be no profit from delivering the CTD bond, but there will be a loss from delivering any other qualifying bond. This is why the CTD concept is very important.
If the yield curve is flat and the YTM is 6% across all maturities, then the conversion factors will be proportional to market price. It is under this condition where there will be no cheapest to deliver. However, we know that the yield curve is no flat, therefore the conversion factor will make it more desirable to deliver a particular bond.
2. What information do we discover when we look at the June13 S&P 500 futures price and the Sept13 S&P 500 futures price? Explain in detail.
If we are given the price of 2 S &P 500 future contracts of different durations, we can find out what t he expected dividend yield would be