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Answer: As bond yields increase, short maturity bonds with low coupons will tend to be the cheapest-to-deliver.
## Explanation Option A is correct because when bond yields increase, the price of bonds decreases. Short maturity bonds with low coupons have lower duration and are less sensitive to interest rate changes compared to long maturity bonds with high coupons. This makes them relatively cheaper to deliver in a rising yield environment. Option B is incorrect because embedded options in Treasury futures contracts (like the quality option, timing option, and wild card option) actually benefit the short position holder, not the long position. These options give the short position flexibility in choosing which bond to deliver and when to deliver, which decreases the value of the futures contract from the long position's perspective. Option C is incorrect because the "wild card play" actually benefits the short position holder, not the long position. The wild card option allows the short position to wait until after the market closes to decide whether to deliver, giving them an advantage if bond prices decline after the close. Option D is incorrect because a downward-sloping yield curve (where long-term rates are lower than short-term rates) typically makes long-maturity bonds more attractive for delivery, not short-maturity bonds. In a downward-sloping yield curve environment, long-maturity bonds with high coupons tend to be the cheapest-to-deliver.
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A derivatives desk trades US Treasury bond futures contracts. A junior analyst is asked to monitor the bond markets and the process of delivering a bond against an expiring futures contract. The analyst studies how changes in market conditions determine which bonds are more likely to be the cheapest-to-deliver and how the process of delivery impacts the futures price. Which of the following observations will 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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