What Does Cheapest to Deliver Mean?

Cheapest to deliver (CTD) in a futures contract is the cheapest security that can be delivered to the long position to satisfy the contract specifications and is relevant only for contracts that allow a variety of slightly different securities to be delivered. This is common in treasury bond futures contracts, which typically specify that any treasury bond can be delivered so long as it is within a certain maturity range and has a certain coupon rate.

Understanding Cheapest to Deliver (CTD)

Determining the cheapest to deliver security is important for the short position because there is often a disparity between the market price of a security and the conversion factor used to determine the value of the security being delivered. This makes it advantageous for the seller to pick a specific security to deliver over another. Since it is assumed that the short position will provide the cheapest to deliver security, the market pricing of futures contracts is generally based on the cheapest to delivery security.

Futures Contracts on Bonds

A futures contract enters the buyer into an obligation to purchase a specific quantity of a particular underlying financial instrument. The seller must deliver the underlying security on a date specified. In cases where multiple financial instruments can satisfy the contract based on the fact that a particular grade was not specified, the seller holding the short position can identify which instrument will be the cheapest to deliver.

Identifying the Cheapest to Deliver

Selecting the cheapest to deliver provides the investor in the short position the ability to maximize his return, or profit, on the bond chosen. The calculation to determine the cheapest to deliver is:

CTD = Current Bond Price – Settlement Price x Conversion Factor

The current bond price is determined based on the current market price with any interest due added to reach a total. Additionally, the calculations are more commonly based on the net amount earned from the transaction, also known as the implied repo rate. Higher implied repo rates result in assets that are cheaper to deliver overall.

Set by the Chicago Board of Trade, the Chicago Mercantile Exchange Group, the conversion factor is required in order to adjust for the varying grades that may be under consideration and is designed to limit certain advantages that may exist when selecting between multiple options. The conversion factors are adjusted as necessary to provide the most useful metric when using the information for calculations.