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Answer: A downward-sloping yield curve makes it more likely that short-maturity bonds will be cheapest-to-deliver.
D is correct. A downward-sloping yield curve tends to favor short-maturity bonds as these are more likely to be the cheapest to deliver. A is incorrect. An increase in yields tends to favor long-maturity low coupon bonds as the cheapest to deliver. B is incorrect. There are two embedded options associated with the delivery of a futures contract - the ability to use the cheapest to deliver bond and the "wild card play" where a short counterparty can choose when to deliver the bond. Both of these options benefit the short counterparty and therefore lower the futures price. C is incorrect. The short counterparty has the right to determine when during the month they will deliver the bond as part of the wild card play. They can also send a notification to deliver after the 2pm closing time so can also exploit a time difference between the settlement of the futures at 2pm and the closing of the bond market later to try and buy the bond cheaper and deliver at the futures price.
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A junior analyst working at a derivatives desk with substantial trading volume has been given the responsibility of monitoring the bond markets and managing the delivery process for US Treasury bond futures contracts. The analyst needs to explore how changes in market conditions impact the identification of the cheapest-to-deliver bonds and understand how these changes affect the pricing of futures contracts. Which of the following statements would the analyst find to be correct?
A
As bond yields increase, short maturity bonds with low coupons will tend to be the cheapest-to-deliver.
B
The embedded options associated with delivery against a US Treasury futures contract tend to increase the value of the contract.
C
The 'wild card play' benefits owners of long positions in expiring futures contracts by allowing them to determine when counterparties holding short positions will deliver.
D
A downward-sloping yield curve makes it more likely that short-maturity bonds will be cheapest-to-deliver.
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