The short position in a US Treasury bond futures contract can select among many different eligible (maturity > 15 years) bonds for delivery. This is by design; the Fed and Treasury do want to see a “run on the issue” if only one bond can be delivered. The conversion factor puts the eligible bonds on a level playing field, making the short almost (but not quite) indifferent to which bond is delivered.

In this way, the short selects a bond for delivery. The bonds have different maturities and coupons. And so different prices. But the long pays the settlement price multiplied by the conversion factor; this is what makes the short almost indifferent to which bond is delivered: bonds with high coupons will have higher conversion factors, the short will receive more for them but they cost more (have higher prices). Bonds with lower conversion factors imply lower a receipt for the short, but they cost more to purchase.

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Comments

1. LUIS OLANO 16 Feb 2009

   David: Good information…........... something to add:

   Conversion Factors: The CBOT has devised a “conversion factor” to help equalize these bonds that are eligible for delivery.

   When a particular bond is delivered, that bond’s conversion factor defines the price received by the seller.

   The amount to be received by the seller is the product of the delivered bond’s conversion factor and the most recently quoted forward price. (Since at this point, the contract has stopped trading, this will be the last trade placed for the particular Treasury Futures Contract).

   Cash received by seller for bond delivered =
         Most Recent Futures Price × Contract size ×          Conversion factor   +  Accrued interest

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