What is a bond future (brief definition)
– A bond future is a standardized derivatives contract that commits one party to buy and another party to sell a specified government bond at a set price on a future date. The contract trades on a futures exchange and can be used to hedge interest-rate exposure, speculate on rate moves, or perform arbitrage.
How they work (step‑by‑step)
1. Contract terms are set on the exchange: which range of bonds are deliverable, expiration month, and the notional size.
2. Two parties take opposite positions: a long (buyer) and a short (seller).
3. Positions are marked to market daily: gains and losses are posted to each party’s margin account every trading day.
4. Before expiry, most traders close or roll their positions. If a short keeps the position through delivery, the short must deliver an eligible bond and the long must accept it and pay the invoice amount.
Key definitions
– Futures contract: an agreement to exchange an asset at a predetermined price on a specified future date.
– Mark-to-market (MTM): daily settlement of gains and losses at the market close price.
– Margin: cash or eligible collateral held by the broker/exchange to cover potential losses. Initial margin is required to open a position; maintenance margin is the minimum that must be kept. A margin call is a demand to top up the account if it falls below the maintenance level.
– Cheapest-to-deliver (CTD): among the pool of eligible bonds for delivery, the bond that minimizes the short’s cost to deliver.
– Conversion factor: a multiplier published by the exchange that adjusts each eligible bond’s price to the contract’s standard coupon assumption so different coupons can be compared fairly.
– Accrued interest: interest accumulated on a bond since the last coupon payment; added to the invoice on delivery.
Delivery mechanics and conversion factors
– Exchanges allow a range of bonds (by maturity and coupon) to satisfy a futures contract. To make bonds comparable, the exchange publishes conversion factors.
– When a short chooses to deliver, the buyer pays the invoice amount:
Invoice amount = Futures settlement price × Conversion factor + Accrued interest
– The short will typically select the CTD bond—the legal delivery that yields the lowest net cost to the short after applying the conversion factor and accounting for accrued interest and financing.
Worked numeric example (invoice price and CTD concept)
– Suppose a Treasury futures settlement price is 120.00. Two eligible bonds have conversion factors and accrued interest:
– Bond A: conversion factor = 0.95; accrued interest = 1.20
– Bond B: conversion factor = 0.90; accrued interest = 0.80
– Compute invoice amount for each:
– Bond A invoice = 120.00 × 0.95 + 1.20 = 114.00 + 1.20 = 115.20
– Bond B invoice = 120.00 × 0.90 + 0.80 = 108.00 + 0.80 = 108.80
– The short would prefer to deliver Bond B because the buyer pays a lower invoice (108.